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CABLE TELEVISION (2)9 Federal Communications Commission Washington, DC 20554 FCC 394 APPLICATION FOR FRANCHISE AUTHORITY CONSENT TO ASSIGNMENT OR TRANSFER OF CONTROL OF CABLE TELEVISION FRANCHISE SECTION I. GENERAL INFORMATION DATE: p2/11 /2000 2. Application for: 1. Community Unit Identification Number: Assignment of Franchise Approved By OMB 3060-0573 FOR FRANCHISE AUTHORITY USE ONLY FL0492 X , Transfer of Control 3. Franchising Authority: CIeBfWatel", Clty 4. Identify community where the system/franchise that is the subject of the assignment or transfer of control is located: Clearwater, City 5. Date system was acquired or (for system's constructed by the transferor/assignor) the date on which servi ce as r'd d t th f' t b b th f h i w p ovi e o e irs su scn er in e ranc ise area. No longer applicable 6. Proposed effective date of closing of the transaction assigning or transferring ownership of the system to transferee/assignee: AS SOOII 8S Pt'BCtIC8bl2 7. Attach as an Exhibit a schedule of any and all additional information or material filed with this application that is identified in the franchise as required to be provided to the franchising authority when requesting its approval of the type of transaction that is the subject of this application. - PART I - TRANSFEROR/ASSIGNOR I Exhibit No. � ; 1 1. Indicate the name, mailing address, and telephone number of the transferor/assignor. Legal name of TransferorlAssignor (if individual, list last name first) Time Warner Inc. Assumed name used for doing business (if any) c/o Time Warner Cable Mailing street address or P.O. Box 290 Harbor Drive City State ZIP Code Telephone No. (include area code) . Stamford CT 06904-2210 (203) 328-0600 2.(a) Attach as an Exhibit a copy of the contract or agreement that provides for the assignment or Exhibit No. transfer of control (including any exhibits or schedules thereto necessary in order to understand the terms thereof). If there is only an oral agreement, reduce the terms to writing and attach. 2 (Confidential trade, business, pricing or marketing information, or other information not otherwise publicly available, may be redacted). (b) Does the contract submitted in response to (a) above embody the full and complete agreement —� — ' X Yes No between the transferor/assignor and the transferee/assignee? — If No, explain in an Exhibit. Exhibit No. N/A FCC 394 (Page 1) September 1996 PART II - TRANSFEREE/ASSIGNEE 1. (a) Indicate the name, mailing address, and telephone number of the transferee/assignee. Legal name of Transferee/Assignee (if individual, list last name first) AOL Time Warner Inc. Assumed name used for doing business (if any) C/O Time Warner Cable Mailing street address or P.O. Box 290 Harbor Drive City State ZIP Code Telephone No. (include area code) Stamford CT 06902 203 328-0600 (b) Indicate the name, mailing address, and telephone number of person to contact, if other than transferee/assignee. Name of contact person (list last name first) Jeff McQuinn, President Firm or company name (if any) Time Warner Communications - Tam a Ba Division Mailing street address or P.O. Box 2600 McCormick Drive, Suite 255 City State ZIP Code Telephone No. (include area code) Clearwater FL 33759 727 791-7730 (c) Attach as an Exhibit the name, mailing address, and telephone number of each additional person Exhibit No. who should be contacted, if any. N/A (d) Indicate the address where the system's records will be maintained. Street Address 2600 McCormick Drive, Suite 255 City State ZIP Code Clearwater FL 33759 2. Indicate on an attached exhibit any plans to change the current terms and conditions of service and operations of the system as a consequence of the transaction for which approval is sought. Exhibit No. 3 FCC 394 (Page 2) September 1996 a SECTION II. TRANSFEREE'S/ASSIGNEE'S LEGAL QUALIFICATIONS 1. Transferee/Assignee is: � Corporation ❑ Limited Partnership ❑ General Partnership a. Jurisdiction of incorporation: b. Date of incorporatian: c. For profit or not-for-profit: a. Jurisdiction in which formed: b. Date of formation: a. Jurisdiction whose laws govern formation d. Name and address of registered agent in jurisdiction: CT Corporation 111 8th Ave., 13th Floor New York, NY 10011 c. Name and address of registered agent in jurisdiction: b. Date of formation: ❑ Individual ❑ Other. Describe in an Exhibit. Exhibit No. N/A 2. List the transferee/assignee, and, if the transferee/assignee is not a natural person, each of its officers, directors, stockholders beneficially holding more than 5% of the outstanding voting shares, general partners, and limited partners holding an equity interest of more than 5%. Use only one column for each individual or entity. Attach additional pages if necessary. (Read carefully - the lettered items below refer to corresponding lines in the following table. ) '(a) Name, residence, occupation or principal business, and principal place of business. (If other than an individual, also show name, address and citizenship of natural person authorized to vote the voting securities of the applicant that it holds. ) List the applicant first,. officers; next, then directors and, thereafter, remaining stockholders and/or partners. (b) Citizenship. (c) Relationship to the transferee/assignee (e.g., officer, director, etc.). (d) Number of shares or nature of partnership interest. 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A� 'S � � � TS Q, "S t�i '' � �- � � �' �, o � �, o � '. � � o ,� 0 � � � � o- � � n, � �. � o�Q = 0 a � � � a � tu � ,� n. � � � � .� o �, � � � �� . � O � G _ 'a C P� � � (D 'a O � � � � `°, n- � � � N o p; r' �' �-' 0 C � p=.. � N N .�• � N y �, �, �, � � o r � T � �- o r' y �' -o � > > -, ry' o � N 0 O y � ° o o Q� � iF � iF -*J c? n. v � d N^�+ a� w " � [-' �' C7 C � o F N � � -+� � N D � � N N � � < O �. w = � o �• y c' C7 � o � � � � � � � � o o rn �' rn � « N ,� * * � �_°. °- � � d N cxo p; �.. � C o � � N N �� ao � �, � � o< � s s o �- <�� 7 ' �. N � �iF O y o \° \° 0 o O� � O� W 3. If the applicant is a corporation or a limited partnership, is the transferee/assignee formed under the laws of, or duly qualified to transact business in, the State or other jurisdiction in which the system operates? If the answer is No, explain in an Exhibit. 4. Has the transferee/assignee had any interest in or in connection with an applicant which has been dismissed or denied by any franchise authority? If the answer is Yes, describe circumstances in an Exhibit. 5. Has an adverse finding been made or an adverse final action been taken by any court or administrative body with respect to the transferee/assignee in a civil, criminal or administrative proceeding,_brought under the provisions of any law or regulation related to the following: any fetony; revocation, suspension or involuntary transfer of any authorization (including cable franchises) to provide video programming services; mass media related antitrust or unfair competition; fraudulent statements to another government unit; or employment discrimination? If the answer is Yes, attach as an Exhibit a full description of the persons and matter(s) involved, including an identification of any court or administrative body and any proceeding (by dates and file numbers, if applicable), and the disposition of such proceeding. 6. Are there any documents, instruments, contracts or understandings relating to ownership or future ownership rights with respect to any attributable interest as described in Question 2(including, but not limited to; non-voting stock interests, beneficial stock ownership interests, options, warrants, debentures)? If Yes, provide particulars in an Exhibit. 7. Do documents, instruments, agreements or understandings for the pledge of stock of the transferee/assignee, as security for loans or contractual performance, provide that: (a) voting rights will remairr with the applicant, even in the event of default on the obligation; (b) in the event of default, there will be either a private or public sale of the stock; and (c) prior to the exercise of any ownership rights by a purchaser at a sale described in (b), any prior consent of the FCC and/or of the franchising authority, if required pursuant to federal, state or local law or pursuant to the terms of the franchise agreement will be obtained? If No, attach as an Exhibit a full explanation. SECTION III. TRANSFEREE'S/ASSIGNEE'S FINANCIAL QUALIFICATIONS 1. The transferee/assignee certifies that it has sufficient net liquid assets on hand or available from committed resources to consummate the transaction and operate the facilities for three months. 2. Attach as an Exhibit the most recent financial statements, prepared in accordance with generally accepted accounting principles, including a balance sheet and income statement for at least one full year, for the transferee/assignee or parent entity that has been prepared in the ordinary course of business, if any such financial statements are routinely prepared. Such statements, if not otherwise publicly available, may be marked CONFIDENTIAL and will be maintained as confidential by the franchise authority and its agents to the extent permissible under local law. SECTION IV. TRANSFEREE'S/ASSIGNEE'S TECHNICAL QUALIFICATIONS Set forth in an Exhibit a narrative account of the transferee's/assignee's technical qualifications, experience and expertise regarding cable television systems, including, but not limited to, summary information about appropriate management personnel that will be involved in the system's management and operations. The transferee/assignee may, but need not, list a representative sample of cable systems currently or formerly owned or operated. � Yes ❑ No Exhibit No. 4 � Yes X❑ No Exhibit No. 5 � Yes � Nc Exhibit No. 6 � Yes � No Exhibit No. � Yes ❑ No Exhibit No. 7 0 Yes ❑ No Exhibit No. 8 Exhibit No. 9 �^� �^� ,�-..-�, �� September 1996 SECTION V - CERTIFICATIONS Part I - Transferor/Assignor All the statements made in the application and attached exhibits are considered material representations, and all the Exhibits are a material part hereof and are incorporated herein as if set out in full in the application. Signature I CERTIFY that the statements in this application are true, complete and correct to the best of my knowledge and belief and are made in good faith. Date — 1� LJ � i.O 0 WILLFUL FALSE STATEMENTS MADE ON THIS FORM ARE --- PUNISHABLE BY FINE AND/OR IMPRISONMENT. U.S. CODE, Print fu�l name TITLE 18, SECTION 1001. Spencer Hays Check appropriate classification: � a � Corporate Officer � Individual General Partner X (Indicate TiUe) Other. Explain: Vice President and Deputy General Counsel Part II - Transferee/Assignee All the statements made in the application and attached Exhibits are considered material representations, and all the Exhibits are a material part hereof and are incorporated herein as if set out in full in the application. The transferee/assignee certifies that he/she: (a) Has a current copy of the FCCs Rules governing cable television systems. (b) Has a current copy of the franchise that is the subject of this application, and of any applicable state laws or local ordinances and related regulations. (c) Will use its best effo�ts to comply with the terms of the franchise and applicable state laws or local ordinances and related regulations, and to effect changes, as promptly as practicable, in the operation system, if any changes are necessary to cure any violations thereof or defaults thereunder presently in effect or ongoing. Signature I CERTIFY that the statements in this application are true, complete and correct to the best of my knowledge and belief and f�� are made in good faith. � Date .--_ WILLFUL FALSE STATEMENTS MADE ON THIS FORM ARE PUNISHABLE BY FINE AND/OR IMPRISONMENT. U.S. CODE, Print fu�� name TITLE 18, SECTION 1001. Thomas McEnerney Check appropriate classification: � Individual � General Partner a Corporate Officer � Other. Explain: (Indicate Title) Vice President FCC 394 (Page 5) September 1996 EXHIBIT 1 The applicable cable franchise does not specify any additional information or material that is required to be provided to the franchising authority in connection with a transfer of control of the franchise. EXHIBIT 2 Attached hereto is the Agreement and Plan of Merger ("Agreement") between America Online, Inc. and Time Warner Inc., dated as of January 10, 2000, including all associated exhibits. The Agreement and exhibits embody the full and complete agreement between America Online, Inc. and Time Warner Inc. with respect to their pending merger, and thus all documents necessary in order to understand the terms of this transaction are being provided. Various schedules referenced in the Agreement contain confidential trade, business, pricing or marketing information, or other information not publicly available, and are not necessary in order to understand the terms of this transaction, are thus are not required to be included. Nevertheless, such documents are available for inspection by appropriate franchising authority officials at any mutually convenient time and in a manner that ensures protection of confidentiality, by contacting the individual listed in Part II, Section I, Question 1(b) of this Form. Pursuant to the Agreement, America Online, Inc. and Time Warner Inc. will each merge into wholly-owned subsidiaries of a new Delaware corporation, AOL Time Warner Inc. Thus, as a result of this merger of equals, AOL Time Warner Inc. will become the new ultimate parent of both America Online, Inc. and Time Warner Inc. The Time Warner related entity that holds the cable franchise for your community will remain in existence and will continue to be the franchise holder and operator of your system, just as before. EXECUTION COPY AGREEMENT AND PLAN OF MERGER DATED AS OF JANUARY 10, 2000 BETWEEN AMERICA ONLINE, INC. AND TIME WARNER INC. oc3-e�-�c��-czz6�-;,��e�crs->:c., Exhibit Exhibit A Exhibit B Exhibit C Exhibit D-1 Exhibit D-2 Exhibit 6.11 Exhibit 7.2(c)(1) Exhibit 7.2(c)(2) Exhibit 7.2(c)(3) LIST OF EXHIBITS Title Stock Option Agreement for Time Warner Stock Option Agreement for America Online Voting Agreement Form of Restated Certificate of Incorporation of Holdco Form of Bylaws of Holdco Form of Affiliate Agreement Form of Holdco Representations Letters Form of America Online Representations Letter Form of Time Warner Representations Letter ��-_�-_��--�_z�.-..�__�_-y-M:::, vi AGREEMENT AND PLAN OF MERGER, dated as of January 10, 2000 (this "A�reement"), between AMERICA ONLINE, INC., a Delaware corporation ("America Online"), and TIME WARNER INC., a Delaware corporacion ("Time Warner"). W�T�T��SETH: WHEREAS, the Boards of Directors of Time Warner and America Online deem it advisable and in the best interests of each corporation and its respective stockholders that Time Warner and America Online engage in a business combination in a merger of equals in order to advance the long-term strategic business interests of Time Warner and America Online; WHEREAS, the combination of Time Warner and America Online shall be effected by the terms of this Agreement through the Mergers (as defined in Section 2.1(b)); WHEREAS, in furtherance thereof, the Board of Directors of each of Time Warner and America Online have approved the applicable Merger, upon the terms and subject to the conditions set forth in this Agreement, pursuant to which each shaze of capital stock of Time Warna and each share of capital stock of America Online issued and outstanding immediately prior to the Effective Time (as defined in Section 2.3) will be converted into the right to receive shares of capital stock of Holdco (as defined in Section l.l) as set forth herein; WHEREAS, (i) as a condition and inducement to America Online's willingness to enter into this Agreement and the America Online Stock Option Agreement referred to below, America Online and Time Wamer are entering into a Stock Option Agreement dated as of the date hereof in the form of Exhibit A(the "Time Warner Stock O tion A�reement") pursuant to which Time Warner is granting to America Online an option to purchase shares of the common stock, paz value $0.01 per share, of Time Wamer ("Time Wamer Common Stock") and (ii) as a condition and inducement to Time Wamer's willingness to enter into this Agreement and the Time Warner Stock Option Agreement, Time Wamer and Amaica Online are entering into a Stock Option Agreement dated as of the date hereof in the form of Exhibit B(the "America Online Stock Option Agreemen�' and, together with the Time Warner Stock Option Agreement, the "Stock O�tion A�reements"), pursuant to which America Online is granting to Time Warner an option to purchase shares of the common stock, par value $0.01 per share, of America Online ("America Online Common Stock"); WHEREAS, as a condition and inducement to America Online's willingness to enter into this Agreement and the America Online Stock Option Agreement, America Online and certain stockholders of Time Warner (the "Designated Stockholders") are entering into an agreement dated as of the date hereof in the form of Exhibit C(the "Voting Agreement") pursuant to which the 0�., � _.-�^G'-72269-:.,.____..,-�;.: Designated Stockholders have agreed, among other things, to vote their shares of Time Warner Common Stock in favor of the adoption of this Agreement; and WHEREAS, for Federal income tax purposes, it is intended that the Mergers shall qualify as exchanges within the meaning of Section 351 of the Internal Revenue Code of 1986, as amended (the "Code"), and as reorganizations within the meaning of Section 368(a) of the Code arid the regulations promulgated thereunder. NOW, THEREFORE, in consideration of the foregoing and the respective representations, warranties, covenants and agreements set forth in this Agreement and in the Stock Option Agreements, and intending to be legally bound hereby and thereby, the parties hereto agree as follows: ARTICLE I FORMATION OF HOLDING COMPANY AND SUBSIDIARIES 1.1 Organization of Holdco. As promptly as practicable following the execution of this agreement and receipt of any required approvals, Time Warner and America Online shall cause a new corporation ("Holdco") to be organized under the laws of the State of Delaware. The certificate of incorporation and bylaws of Holdco shall initially be as agreed upon by Time Warner and America Online. The authorized capital stock of Holdco shall initially consist of 100 shares of common stock, par value $0.01 per share (the "Holdco Common Stock"), of which one share shall be issued to Time Warner and one shaze shall be issued to America Online. Time Warner and America Online shall take, and shall cause Holdco to take, all requisite action to cause the certificate of incorporation of Holdco to be in the form of Exhibit D-1 (the "Holdco Charter") and the bylaws of Holdco to be in the form of Exhibit D-2 (the "Holdco B l�aws"), in each case, at the Effective Time. 1.2 Directors and Officers of Holdco. Prior to the Effective Time, the directors and officers of Holdco shall consist of equal numbers of representatives of America Online and Time Warner and shall initially be as designated and elected by Time Wamer and America Online. Time Warner and America Online shall take all requisite action to cause the directors and officers of Holdco as of the Effective Time to be as provided in Section 6.2. Each such director and officer shall remain in office until his or her successors are elected in accordance with Schedule 6.2(a) and the Holdco Bylaws. 1.3 Organization of Merger Subsidiaries. As promptly as practicable following the execution of this Agreement, Holdco shall cause to be organized for the sole purpose of effectuating the Mergers contemplated herein: C.^��"c�—OOC i—G226y—r+O1cECii9—?:�.�. 2 (a) a corporation organized under the laws of the State of Delaware ("Time Warner Merger Sub"); the certificate of incorporation and bylaws of Time Warner Merger Sub shall be in such forms as shall be determined by Holdco as soon as practicable following the execution of this Agreement and the authorized capital stock of Time Warner Merger Sub shall initially consist of 100 shares of common stock, �ar value $0.01 per shaze, all of which shares shall be issued to Holdco at a price of $1.00 per share; and (b) a corporation organized under the laws of the State of Delaware ("America Online Mer eg r Sub" and, together with Time Warner Merger Sub, the "Mer�er Subsidiaries"); the certificate of incorporation and bylaws of America Online Merger Sub shall be in such forms as shall be determined by Holdco as soon as practicable following the execution of this Agreement; and the authorized capital stock of America Online Merger Sub shall initially consist of 100 shares of common stock, par value $0.01 per share, all of which shares shall be issued to Holdco at a price of $1.00 per share. 1.4 Actions of Directors and O�cers. As promptly as practicable following the execution of this Agreement, Time Warner and America Online shall take all requisite action to designate the directors and officers of Holdco and each of the Merger Subsidiaries and to take such steps as may be necessary or appropriate to complete the organization of Holdco and the Merger Subsidiaries. Time Warner and America Online shall cause the directors of Holdco to ratify and approve this Agreement, and the directors of the Merger Subsidiaries to ratify and approve this Agreement. 1.5 Actions of Time Warner and America Online. As promptly as practicable following the execution of this Agreement, Time Warner and America Online, as the holders of all the outstanding shares of Holdco Common Stock, shall adopt this Agreement and shall cause Holdco, as the sole stockholde�' of each of the Merger Subsidiaries, to adopt this Agreement. Each of Time Warner and America Online shall cause Holdco, and Holdco shall cause the Merger Subsidiaries, to perform their respective obligations under this Agreement. As promptly as practicable after the date hereof the parties shall cause this Agreement to be amended to add Holdco and the Merger Subsidiaries as parties hereto and each Merger Subsidiary shall become a constituent corporation in its respective Merger. ARTICLE II THE MERGERS; CERTAIN RELATED MATTERS 2.1 The Mergers. Upon the terms and subject to the conditions set forth in this Agreement, and in accordance with the Delawaze General Corporation Law (the "DGCL"), except as set foRh on Schedule 2.1: 003;��-oc� -�%zES-.;cie��y-vcr. 3 (a) Time Wamer Merger Sub shall be merged with and into Time Warner (the "Time Warner Merger"). Time Warner shall be the surviving corporation in the Time Warner Merger and shall continue its corporate existence under the laws of the State of Delaware. As a result of the Time Warner Merger, Time Warner shall become a wholly owned subsidiary of Holdco. (b) America Online Merger Sub shall be merged with and into America Online (the "America Online Merger"). America Online shall be the surviving corporation in the America Online Merger and shall continue its corporate existence under the laws of the State of Delaware. As a result of the America Online Merger, America Online shall become a wholly owned subsidiary of Holdco. The Time Warner Merger and the America Online Merger are together referred to herein as the "Me� ". 2.2 Clo in . Upon the terms and subject to the conditions set forth in Article VII and the termination rights set forth in Article VIII, the closing of the Mergers (the "Closin ") will take place on the first Business Day after the satisfaction or waiver (subject to applicable law) of the conditions (excluding conditions that, by their nature, cannot be satisfied until the Closing Date (as defined below)) set forth in Article VII, unless this Agreement has been theretofore terminated pursuant to its terms or unless another time or date is agreed to in writing by the parties hereto (the actual time and date of the Closing being referred to herein as the "Closing Date"). The Closing shall be held at the offices of Simpson Thacher & Bartlett, 425 Lexington Avenue, New York, New York, 10017, unless another place is agreed to in writing by the parties hereto. 2.3 Effective Time. As soon as practicable following the satisfaction or waiver (subject to applicable law) of the conditions set forth in Article VII, at the Closing the parties shall file the Certificates of Merger (as defined below) with the Secretary of State of the State of Delaware in such form as is required by and executed and acknowledged in accordance with the relevant provisions of the DGCL and make all other filings or recordings required under the DGCL. The Mergers shall become effective at (i) the date and time both of the certificate of merger relating to the Time Warner Merger (the "Time Warner Certificate of Mer�er") and the certificate of inerger relating to the America Online Merger (the "America Online Certificate of Mer er" and, together with the Time Warner Certificate of Merger, the "Certificates of Mer�er") are duly filed with the Secretary of State of the State of Delaware or (ii) such subsequent time as America Online and Time Warner shall agree and as shall be specified in the Certificates of Merger; provided that both Mergers shall become effective at the same time (such time as the Mergers become effective being the "Effective Time"). 2.4 Effects of the Mergers. At and after the Effective Time, the Mergers will have the effects set forth in the DGCL. Cc3%5c-cCO�-o�2o�-�C_e�c-5-�:�=, 4 2.5 Charters and B ly aws. (a) Certificates of Incorporation. The Restated Certificate of Incorporation of Time Warner, as in effect immediately prior to the Effective Time, shall be the certificate of incorporation of the surviving corporation in the Time Wamer Merger. The Restated Certificate of Incorporation of America Online, as in effect immediately prior to the Effective Time, shall be the certificate of incorporation of the surviving corporation in the America Online Merger. (b) B�laws. The bylaws of Time Warner, as in effect immediately prior to the Effective Time, shall be the bylaws of the surviving corporation in the Time Warner Merger. The bylaws of America Online, as in effect immediately prior to the Effective Time, shall be the bylaws of the surviving corporation in the America Online Merger. 2.6 Officers and Directors. The officers and directors of Time Warner Merger Sub immediately prior to the Effective Time shall be the officers and directors of tize surviving corporation in the Time Warner Merger. The officers and directors of America Online Merger Sub immediately prior to the Effective Time shall be the officers and directors of the surviving corporation in the America Online Merger. 2.7 Effect on Time Wamer Capital Stock. As of the Effective Time, by virtue of the Time Warner Merger and without any action on the part of the holder of any shares of Time Warner Capital Stock (as defined in Section 2.7(c)) or any shares of capital stock of Time Warner Merger Sub: (a) Capital Stock of Time Warner Mer e�? r Sub. Each issued and outstanding share of common stock, par value $0.01 per share, of Time Warner Merger Sub shall be converted into the right to receive one fully paid and nonassessable share of common stock, par value $.O 1 per share, of the surviving corporation in the Time Warner Merger. (b) Cancellation of Treasury Stock. Subject to Section 3.5, each share of Time Warner Capital Stock issued and owned or held by Time Warner at the Effective Time shall, by virtue of the Time Warner Merger, cease to be outstanding and shall be canceled and retired, and no consideration shall be delivered in exchange therefor. (c) Conversion of Time Warner Capital Stock. Subject to Section 3.5, each issued and outstanding share of Time Warner Capital Stock (other than shares to be canceled in accordance with Section 2.7(b) and other than shares subject to Section 2.10) shall be converted into the right to receive fully paid and nonassessable shares of Holdco Capital Stock (as defined below) in accordance with the following table: '�1�.�.�C�V-l�vl�%-�2LEa_:'.�.�:.r..^.7':�:�%i � . Each Share of the Specified Number and Class or Series of Shares of Class or Series of Time Warner Capital Stock Holdco Capital Stock Into Which Converted Time Wamer Common Stock . . . . . . . . . . . . . 1.5 shares (as the same may be adjusted according to Section 2.9, the "Exchanee Ratio") of Holdco Common Stock Time Warner Series LMCN-V Common ..... 1.5 shares of Series LMCN-V Common Stock, par value $0.01 per share ("Time Warner Series LMCN-V Common Stock") Time Warner Series LMC Common . . . . . . . . Stock, par value $0.01 per share ("Time Warner Series LMC Common tock") Time Warner Series E Convertible . . . . . . . . . Preferred Stock, par value �0.10 per share ("Time Warner Series E Preferred Stock") c�s-��-oco--�2_�.-..�_s�`-�-�:c.. 6 Stock, par value $0.01 per share, of Holdco ("Holdco Series LMCN-V Common Stock"); provided that the "Formula Number" (as defined in the Certificate of Designations for the Time Wamer Series LMCN-V Common Stock (the "Series LMCN-V Certificate")) in effect immediately prior to the Effective Time shall be the Formula Number for the Holdco Series LMCN-V Common Stock issued pursuant to the Mergers and no adjustment to the Formula Number or conversion rights of such stock shall be made pursuant to the terms of the Series LMCN-V Certificate, including Section 3.6 thereof 1.5 shares of Series LMC Common Stock, par value $0.01 per share, of Holdco ("Holdco Series LMC Common Stock"); provided that the "Formula Number" (as defined in the Certificate of Designations for the Time Warner Series LMC Common Stock (the "Series LMC Certificate")) in effect immediately prior to the Effective Time shall be the Formula Number for the Holdco Series LMC Common Stock issued pursuant to the Mergers and no adjustment to the Formula Number or conversion rights of such stock shall be made pursuant to the terms of the Series LMC Certificate, including Section 3.6 thereof One share of Series E Convertible Preferred Stock, par value $0.10 per share, of Holdco ("Holdco Series E Preferred St�ck") Each Share of the Specified Class or Series of Time Warner Capital Stock Time Warner Series F Convertible . . . . . . . . . Prefened Stock, par value $0.10 per share ("Time Warner Series F Preferred Stock") Time Warner Series I Convertible . . . . . . . . . Preferred Stock, par value $0.10 per shaze ("Time Warner Series F Preferred Stock") Time Wamer Series J Convertible . . . . . . . . . . Preferred Stock, par value $0.10 per share ("Time Warner Series J Preferred Stock" and together, with Time Warner Series E Preferred Stock, Time Warner Series F Preferred Stock and Time Warner Series I Preferred Stock, the "Time Warner Preferred Stock") Number and Class or Series of Shares of Holdco Ca�ital Stock Into Which Converted One share of Series F Convertible Preferred Stock, par value $0.10 per share, of Hoidco ("Holdco Series F Preferred Stock") One share of Series I Convertible Preferred Stock, par value $0.10 per share, of Holdco ("Holdco Series I Preferred Stock") One share of Series J Convertible Preferred Stock, par value $0.10 per share, of Holdco ("Holdco Series J Prefened Stock" and, . together with Holdco Common Stock, Holdco Series LMCN-V Common Stock, Holdco Series LMC Common Stock, Holdco Series E Preferred Stock, Holdco Series F Preferred Stock and Holdco Series I Preferred Stock, the "Holdco Capital Stock") The Time Warner Series LMCN-V Common Stock and the Time Warner Series LMC Common Stock are referred to herein collectively as the "Time Warner Series Common Stock." The Time Warner Common Stock, the Time Warner Series Common Stock and the Time Warner Preferred Stock are referred to herein collectively as the "Time Warner Capital Stock." The shares of Holdco Capital Stock into which shazes of Time Warner Capital Stock are converted pursuant to the foregoing are referred to herein collectively as the "Time Warner Mer,�er Consideration." As a result of the Time Warner Merger and without any action on the part of the holders thereof, at the Effective Time, all shares of Time Warner Capital Stock shall cease to be outstanding and shall be canceled and retired and shall cease to exist, and each holder of a certificate which immediately prior to the Effective Time represented any such shares of Time Warner Capital Stock (such certificate or other evidence of ownership, a"Time Warner Certificate") shall thereafter cease to have any rights with respect to such shares of Time Wamer Capital Stock, except the right (subject to Section 2.10) to receive the applicable Time Warner Merger Consideration with respect thereto and any cash in lieu of fractional shares of applicable Holdco Capital Stock with respect thereto to be issued in consideration therefor and any �a3 �ec-�oo �-o2zo5-r.e�_2ec-5-�:�;, dividends or other distributions to which holders of Time Warner Capital Stock become entitled all in accordance with Article III upon the surrender of such Time Warner Certificate. 2.8 Time Warner Stock Options and Other Equitv-Based Awards. (a) Each Time Warner Stock Option (as defined in Section 4.2(b)) granted prior to the Effective Time and which remains outstanding immediately prior to the Effective Time shall cease to represent a right to acquire shares of Time Warner Common Stock and shall be converted (each, as so converted, a"Time Wamer Converted Option"), at the Effective Time, into an option to acquire, on the same terms and conditions as were applicable under the Time Warner Stock Option (but taking into account any changes thereto, including the acceleration thereof, provided for in the Time Warner Stock Option Plans (as defined in Section 4.2(b)), in any award agreement or in such option by reason of this Agreement or the transactions contemplated hereby), that number of shares of Holdco Common Stock determined by multiplying the number of shares of Time Warner Common Stock subject to such Time Wamer Stock Option by the Exchange Ratio, rounded, if necessary, to the nearest whole share of Holdco Common Stock, at a price per share (rounded to the nearest one-hundredth of a cent) equal to the per share exercise price specified in such Time Warner Stock Option divided by the Exchange Ratio; provided, however, that in the case of any Time Warner Stock Option to which Section 421 of the Code applies by reason of its qualification under Section 422 of the Code, the option price, the number of shares subject to such option and the terms and conditions of exercise of such option shall be determined in a manner consistent with the requirements of Section 424(a) of the Code. (b) Each restricted share of Time Warner Common Stock granted pursuant to the Time Warner Stock Option Plans (each such share, a"Time Warner Restricted Share" and, together with each other Time Warner Restricted Shaze outstanding as of the date hereof and all other restricted shares granted by Time Warner after the date hereof in accordance with the Time Warner Stock Option Plans and Section 5.2, the "Time Warner Restricted Shares") which is outstanding immediately prior to the Effective Time shall vest and become free of restrictions to the extent provided by the terms thereof. Each award of Time Wamer Restricted Shares shall be converted, as of the Effective Time, into that number of shazes of Holdco Common Stock determined by multiplying the number of shazes subject to the award by the Exchange Ratio; and the aggregate number of shares of Holdco Common Stock as so determined shall be delivered to the respective holders of Time Warner Restricted Shares as soon as practicable following the Effective Time. America Online acknowledges that the acceleration of vesting as a result of the Time Warner Merger of all Time Wamer Stock Options outstanding as of January 9, 2000 in accordance with their terms shall not constitute a Material Adverse Effect on Time Wamer. (c) As soon as practicable after the Effective Time, Holdco shall deliver to the holders of Time Warner Stock Options appropriate notices setting forth such holders' rights pursuant to the respective Time Warner Stock Option Plans and agreements evidencing the grants of such Time Warner Stock Options (including that, in connection with the Time Warner 00_- � �-0007-022c9-;-.�i?EC:?9-'Y,GA Merger and to the extent provided by the terms of the Time Warner Stock Option Plans, the Time Warner Stock Options have become fully vested and exercisable) and stating that such Time Warner Stock Options and agreements shall be assumed by Holdco and shall continue in effect on the same terms and conditions (subject to the adjustments required by this Section 2.8 after giving effect to the Time Warner Merger and the terms of the Time Warner Stock Option Plans). To the extent permitted by law, Holdco shall comply with the terms of the Time Warner Stock Option Plans and shall take such reasonable steps as aze necessary or required by, and subject to the provisions of, such Time Warner Stock Option Plans, to have the Time Wamer Stock Options which qualified as incentive stock options prior to the Effective Time continue to qualify as incentive stock options of Holdco after the Effective Time. (d) Prior to the Effective Time, Holdco shall take all necessary action to assume as of the Effective Time all obligations undertaken by, or on behalf of Holdco under this Section 2.8 and to adopt at the Effective Time the Time Warner Stock Option Plans and each Time Warner Converted Option, and to take all other actions called for by this Section 2.8, including the reservation, issuance and listing of a number of shares of Holdco Common Stock at least equal to the number of shares of Holdco Common Stock that will be subject to Time Warner Converted Options. No later than the Effective Time, Holdco shall file a registration statement on Form S-8 (or any successor or, including if Form S-8 is not available, other appropriate forms) with respect to the shares of Holdco Common Stock subject to such options or restricted shares and shall maintain the effectiveness of such registration statement or registration statements (and maintain the current status of the prospectus or prospectuses contained therein) for so long as such options or restricted shazes remain outstanding. 2.9 Certain Ad�ustments. If, between the date of this Agreement and the Effective Time (and as permitted by Sections 5.1 and 5.2), the outstanding shares of America Online Common Stock or the outstanding shares of Time Warner Common Stock or Time Warner Series Common Stock shall have been increased, decreased, changed into or exchanged for a different number of shares or different class, in each case, by reason of any reclassification, recapitalization, stock split, split-up, combination or exchange of shares or a stock dividend or dividend payable in any other securities shall be declared with a record date within such period, or any similar event shall have occurred, the applicable Merger Consideration (as defined in Section 2.11(c)) shall be appropriately adjusted to provide to the holders of Time Warner Common Stock, Time Warner Series Common Stock and America Online Common Stock the same economic effect as contemplated by this Agreement prior to such event. 2.10 Time Wamer Appraisal Ri�hts. (a) Notwithstanding attything in this Agreement to the contrary and unless provided for by applicable law, shazes of Time Warner Series Common Stock and Time Warner Preferred Stock that are issued and outstanding immediately prior to the Effective Time and that are owned by stockholders who have properly perfected their rights of appraisal within the meaning of Section 262 of the DGCL (the "Time Warner Dissentin Sg hares") shall not be converted into the right to receive the applicable Time Warner Merger Consideration with respect thereto, unless and until such stockholders shall have C0373�-0007-02269-A018ECH9-MGA 7 (c) As soon as practicable after the Effective Time, Holdco shall deliver to the holders of America Online Stock Options appropriate notices setting forth such holders' rights pursuant to the respective America Online Stock Option Plans and agreements evidencing the grants of such America Online Stock Options (including that, in connection with the America Online Merger and to the extent provided by the terms of the America Online Stock Option Plans, the America Online Stock Options have become fully vested) and stating that such America Online Stock Options and agreements shall be assumed by Holdco and shall continue in effect on the same terms and conditions (subject to the adjustments required by this Section 2.12 after giving effect to the America Online Merger and the terms of the America Online Stock Option Plans). To the extent permitted by law, Holdco shall comply with the terms of the America Online Stock Option Plans and shall take such reasonable steps as are necessary or required by, and subject to the provisions of, such America Online Stock Option Plans, to have the America Online Stock Options which qualified as incentive stock options prior to the Effective Time continue to qualify as incentive stock options of Holdco after the Effective Time. (d) Prior to the Effective Time, Holdco shall take all necessary action to assume as of the Effective Time all obligations undertaken by, or on behalf of Holdco under this Section 2.12 and to adopt at the Effective Time the America Online Stock Option Plans and each America Online Converted Option, and to take all other actions called for by this Section 2.12, including the reservation, issuance and listing of a number of shares of Holdco Common Stock at least equal to the number of shazes of Holdco Common Stock that will be subject to America Online Converted Options. No later than the Effective Time, Holdco shall file a registration statement on Form S-8 (or any successor or, including if Form S-8 is not available, other appropriate forms) with respect to the shares of Holdco Common Stock subject to such options or restricted shares and shall maintain the effectiveness of such registration statement or registration statements (and maintain the current status of the prospectus or prospectuses contained therein) for so long as such options or restricted shares remain outstanding. ARTICLE III EXCHANGE OF CERTIFICATES 3.1 Exchan e�. Fund. Prior to the Effective Time, America Online shall appoint a commercial bank or trust company reasonably acceptable to Time Warner, or a subsidiary thereof, to act as exchange agent hereunder for the purpose of exchanging Certificates for the applicable Merger Consideration (the "Exchange Agent"). At or prior to the Effective Time, Holdco shall deposit with the Exchange Agent, in trust for the benefit of holders of shares of Time Wamer Capital Stock and America Online Common Stock, certificates representing the shares of the Holdco Capital Stock issuable pursuant to Sections 2.7 and 2.11 in exchange for outstanding shares of Time Warner Capital Stock and America Online Common Stock. Holdco agrees to make available to the Exchange Agent from time to time as needed, cash sufficient to pay cash in lieu of fractional shares pursuant to Section 3.5 and any dividends and other co3�eo-coo;-�zzo5-�.o�p�cy5-�:c=, 12 distributions pursuant to Section 3.3. Any cash and certificates representing Holdco Capital Stock deposited with the Exchange Agent shall hereinafter be referred to as the "Exchan�e Fund". 3.2 Exchange Procedures. Promptly after the Effective Time, Holdco shall cause the Exchange Agent to mail to each holder of a Certificate (i) a letter of transmittal which shall specify that delivery shall be effected, and risk of loss and title to the Certificates shall pass, only upon proper delivery of the Certificates to the Exchange Agent, and which letter shall be in customary form and have such other provisions as America Online or Time Warner may reasonably specify (such letter to be reasonably acceptable to Time Warner and America Online prior to the Effective Time) and (ii) instructions for effecting the surrender of such Certificates in exchange for the applicable Merger Consideration, together with any dividends and other distributions with respect thereto and any cash in lieu of fractional shazes. Upon surrender of a Certificate to the Exchange Agent together with such letter of transmittal, duly executed and completed in accordance with the instructions thereto, and such other documents as may reasonably be required by the Exchange Agent, the holder of such Certificate shall be entitled to receive in exchange therefor (A) one or more shares of Holdco Capital Stock (which shall be in uncertificated book-entry form unless a physical certificate is requested or is otherwise required by applicable law or regulation) representing, in the aggregate, the whole number of shares that such holder has the right to receive pursuant to Sections 2.7 or 2.11 (after taking into account all shares of Time Warner Capital Stock and America Online Common Stock then held by such holder) and (B) a check in the amount equal to the cash that such holder has the right to receive pursuant to the provisions of this Article III, including cash in lieu of any fractional shares of Holdco Capital Stock pursuant to Section 3.5 and dividends and other distributions pursuant to Section 3.3. No interest will be paid or will accrue on any cash payable pursuant to Section 3.3 or Section 3.5. In the event of a transfer of ownership of Time Warner Capital Stock which is not registered in the transfer records of Time Warner or a transfer of ownership of America Online Common Stock which is not registered in the transfer records of America Online, one or more shares of Holdco Capital Stock evidencing, in the aggregate, the proper number of shares of Holdco Capital Stock, a check in the proper amount of cash in lieu of any fractional shazes of Holdco Capital Stock pursuant to Section 3.5 and any dividends or other distributions to which such holder is entitled pursuant to Section 3.3, may be issued with respect to such Time Wamer Capital Stock or America Online Common Stock to such a transferee if the Certificate representing such shares of Time Warner Capital Stock or America Online Common Stock is presented to the Exchange Agent, accompanied by all documents required to evidence and effect such transfer and to evidence that any applicable stock transfer taxes have been paid. 3.3 Distributions with Res�ect to Unexchanged Shares. No dividends or other distributions with a record date after the Effective Time shall be paid to the holder of any unsurrendered Certificate with respect to the shares of Holdco Capital Stock that such holder would be entitled to receive upon surrender of such Certificate and no cash payment in lieu of fractional shares of Holdco Capital Stock shall be paid to any such holder pursuant to Section 3.5 until such holder shall surrender such Certificate in accordance with Section 3.2. Subject to the oos�ao-ooe�-czz6�-;-.oieec�9-v�a 13 effect of applicable laws, following surrender of any such Certificate, there shall be paid to the record holder thereof without interest, (a) promptly after the time of such surrender, the amount of any cash payable in lieu of fractional shares of Holdco Capital Stock to which such holder is entitled pursuant to Section 3.5 and the amount of dividends or other distributions with a record date after the Effective Time theretofore paid with respect to such whole shares of Holdco Capital Stock, and (b) at the appropriate payment date, the amount of dividends or other distributions with a record date after the Effective Time and a payment date subsequeni to such surrender payable with respect to such shares of Holdco Capital Stock. 3.4 No Further Ownership Rights in Time Warner Capital Stock or America Online Common Stock. All shares of Holdco Capital Stock issued and cash paid upon conversion of shares of Time Warner Capital Stock or America Online Common Stock in accordance with the terms of Article II and this Article III (including any cash paid pursuant to Sections 3.3 or 3.5) shall be deemed to have been issued or paid in full satisfaction of all rights pertaining to the shares of Time Warner Capital Stock or America Online Common Stock. 3.5 No Fractional Shares of Holdco Capital Stock. (a) No certificates or scrip or shares of Holdco Capital Stock representing fractional shares of Holdco Capital Stock or book-entry credit of the same shall be issued upon the surrender for exchange of Certificates and such fractional share interests will not entitle the owner thereof to vote or to have any rights of a stockholder of Holdco or a holder of shares of Holdco Capital Stock. (b) Notwithstanding any other provision of this Agreement, each holder of shares of Time Warner Common Stock exchanged pursuant to the Time Warner Merger who would otherwise have been entitled to receive a fraction of a share of Holdco Common Stock or Holdco Series Common Stock (determined after taking into account all Certificates delivered by such holder) shall receive, in lieu thereof, cash (without interest) in an amount equal to the product of (i) such fractional part of a share of Holdco Common Stock multiplied by (ii) the closing price for a share of Holdco Common Stock as reported on the New York Stock Exchange, Inc. ("NYSE") Composite Transactions Tape on the first trading day following the date on which the Effective Time occurs. As promptly as practicable after the determination of the amount of cash, if any, to be paid to holders of fractional interests, the Exchange Agent shall so notify Holdco, and Holdco shall deposit such amount with the Exchange Agent and shall cause the Exchange Agent to forward payments to such holders of fractional interests subject to and in accordance with the terms hereof. 3.6 Termination of Exchan eg�Fund. Any portion of the Exchange Fund which remains undistributed to the holders of Certificates for six months after the Effective Time shall, at Holdco's request, be delivered to Holdco or otherwise on the instruction of Holdco, and any holders of the Certificates who have not theretofore complied with this Article III shall after such delivery look only to Holdco for the Merger Consideration with respect to the shares of uC3'8v-COJ?-02269-r'.018�CH9-^;GA 14 Time Warner Capital Stock or America Online Common Stock formerly represented thereby to which such holders are entitled pursuant to Sections 2.7, 2.11 and 3.2, any cash in lieu of fractional shares of Holdco Capital Stock to which such holders are entitled pursuant to Section 3.5 and any dividends or distributions with respect to shares of Holdco Capital Stock to which such holders are entitled pursuant to Section 3.3. Any such portion of the Exchange Fund remaining unclaimed by holders of shares of Time Warner Capital Stock or America Online Common Stock immediately prior to such time as such amounts would otherwise escheat to or become property of any Governmental Entity (as defined in Section 4.1(c)(iii)) shall, to the extent permitted by law, become the property of Holdco free and clear of any claims or interest of any Person previously entitled thereto. 3.7 No Liabilitv. None of Holdco, America Online, America Online Merger Sub, Time Warner, Time Warner Merger Sub or the Exchange Agent shall be liable to any Person in respect of any Merger Consideration from the Exchange Fund delivered to a public official pursuant to any applicable abandoned property, escheat or similar law. 3.8 Investment of the Exchan eg Fund. The Exchange Agent shall invest any cash included in the Exchange Fund as directed by Holdco on a daily basis; .provided that no such investment or loss thereon shall affect the amounts payable to Time Warner or America Online stockholders pursuant to Article II and the other provisions of this Article III. Any interest and other income resulting from such investments shall promptly be paid to Holdco. 3.9 Lost Certificates. If any Certificate shall have been lost, stolen or destroyed, upon the making of an affidavit of that fact by the Person claiming such Certificate to be lost, stolen or destroyed and, if required by Holdco, the posting by such Person of a bond in such reasonable amount as Holdco may direct as indemnity against any claim that may be made against it with respect to such Certificate, the Exchange Agent will deliver in exchange for such lost, stolen or destroyed Certificate the applicable Merger Consideration with respect to the shares of Time Wamer Capital Stock or America Online Common Stock formerly represented thereby, any cash in lieu of fractional shares of Holdco Capital Stock, and unpaid dividends and distributions on shares of Holdco Capital Stock deliverable in respect thereof, pursuant to this Agreement. 3.10 Withholdin�Rights. Holdco shall be entitled to deduct and withhold from the consideration otherwise payable pursuant to this Agreement to any holder of shares of Time Warner Capital Stock or America Online Common Stock such amounts as it is required to deduct and withhold with respect to the making of such payment under the Code and the rules and regulations promulgated thereunder, or any provision of state, local or foreign tax law. To the extent that amounts are so withheld by Holdco, such withheld amounts shall be treated for all purposes of this Agreement as having been paid to the holder of the shares of Time Warner Capital Stock or America Online Common Stock in respect of which such deduction and withholding was made by Holdco. C03720-0007-02269-ACi85CE9-M�A 15 3.11 Further Assurances. At and after the Effective Time, the officers and directors of Holdco will be authorized to execute and deliver, in the name and on behalf of America Online, America Online Merger Sub, Time Warner or Time Warner Merger Sub, any deeds, bills of sale, assignments or assurances and to take and do, in the name and on behalf of America Online, America Online Merger Sub, Time Warner or Time Wamer Merger Sub, any other actions and things to vest, perfect or confirm of record or otherwise in Holdco any and all right, title and interest in, to and under any of the rights, properties or assets acquired or to be acquired by Holdco as a result of, or in connection with, the Mergers. 3.12 Stock Transfer Books. The stock transfer books of Time Warner and America Online shall be closed immediately upon the Fffective Time and there shall be no further registration of transfers of shares of Time Warner Capital Stock or America Online Common Stock thereafter on the records of Time Warner or America Online. On or after the Effective Time, any Certificates presented to the Exchange Agent or Holdco for any reason shall be converted into the right to receive the applicable Merger Consideration with respect to the shares of Time Warner Capital Stock or America Online Common Stock formerly represented thereby (including any cash in lieu of fractional shares of Holdco Capital Stock to which the holders thereof are entitled pursuant to Section 3.5 and any dividends or other distributions to which the holders thereof are entitled pursuant to Section 3.3). ARTICLE IV REPRESENTATIONS AND WARRANTIES 4.1 Representations and Warranties of America Online. Except as disclosed in the America Online Filed SEC Reports (as defined in Section 4.1(d)(ii)) or as set forth in the America Online Disclosure Schedule delivered by America Online to Time Warner prior to the execution of this Agreement (the "America Online Disclosure Schedule"), America Online represents and warrants to Time Warner as follows: (a) Organization Standing and Power: Subsidiaries. (i) Each of America Online and each of its Subsidiaries (as defined in Section 9.11) is a corporation or other organization duly organized, validly existing and in good standing under the laws of its jurisdiction of incorporation or organization, has the requisite power and authority to own, lease and operate its properties and to cazry on its business as now being conducted, except where the failure to be so organized, existing and in good standing or to have such power and authority, individually or in the aggregate, would not reasonably be expected to have a Material Adverse Effect (as defined in Section 9.11) on America Online, and is duly qualified and in good standing to do business in each jurisdiction in which the nature of its business or the ownership or leasing of its properties makes such qualification necessary other than in such jurisdictions where the failure so to qualify or to be in good standing, individually or 0::3-5�-CCi.�-02269-i-.G: BECF.9-:�fGA 16 in the aggregate, would not reasonably be expected to have a Material Adverse Effect on America Online. The copies of the certificate of incorporation and bylaws of America Online which were previously furnished or made available to Time Wamer are true, complete and correct copies of such documents as in effect on the date of this Agreement. (ii) Exhibit 21 to America Online's Annual Report on Form 10-K for the fiscal year ended June 30, 1999 includes all the Subsidiaries of America Online which as of the date of this Agreement are Significant Subsidiaries (as defined in Rule 1-02 of Regulation S-X of the Securities and Exchange Commission (the "�EC")). All the outstanding shares of capital stock of, or other equity interests in, each such Significant Subsidiary have been validly issued and are fully paid and nonassessable and are, except as set forth in such Exhibit 21, owned directly or indirectly by America Online, free and clear of all pledges, claims, liens, charges, encumbrances and security interests of any kind or nature whatsoever (collectively "Liens") and free of any other restriction (including any restriction on the right to vote, sell or otherwise dispose of such capital stock or other ownership interests), except for restrictions imposed by applicable securities laws. Except as disclosed in Section 4.1(a) of the America Online Disclosure Schedule, as of the date of this Agreement, neither America Online nor any of its Subsidiaries directly or indirectly owns any equity or similar interest in, or any interest convertible into or exchangeable or exercisable for, any corporation, partnership, joint venture or other business association or entity (other than Subsidiaries), that is or would reasonably be expected to be material to America Online and its Subsidiaries taken as a whole. (b) Capital Structure. (i) As of January 5, 2000, the authorized capital stock of America Online consists of (A) 6,000,000,000 shazes of America Online Common Stock, of which 2,274,045,973 shares were outstanding and (B) 5,000,00� shares of Preferred Stock, par value $0.01 per share, none of which were outstanding and 500,000 of which have been designated Series A-1 Junior Participating Preferred Stock and reserved for issuance upon exercise of the rights (the "America Online R�hts") distributed to the holders of America Online Common Stock pursuant to the Rights Agreement, dated as of May 12, 1998 between America Online and BankBoston, N.A., as Rights Agent (the "America Online Ri�hts Agreement"). Except as disclosed in Section 4.1(b) of the America Online Disclosure Schedule, since January 5, 2000 to the date of this Agreement, there have been no issuances of shares of the capital stock of America Online or any other securities of America Online other than pursuant to options or rights outstanding as of January 5, 2000 under the Benefit Plans (as defined in Section 9.11(b)) of America Online or conversion of convertible debt securities of America Online. All issued and outstanding shares of the capital stock of America Online are duly authorized, validly issued, fully paid and nonassessable and free of any preemptive rights. There were outstanding as of January 5, 2000 no options, warrants or other rights to acquire capital stock from America Online other than (x) the America Online Rights, (y) options and other rights to acquire America Online Common Stock from America Online representing in the aggregate the right to purchase approximately 376,107,825 shares of America Online Common Stock (such options, together with the other employee stock options co37a�-coc--o�zEo-;;o:e�c::�-vca. 17 issued by America Online after the date hereof in accordance with the America Online Stock Option Plans and Section 5.1, collectively, the "America Online Stock Options") under America Online's Employee Stock Purchase Plan, 1992 Employee, Director and Consultant Stock Option Plan, Quantum Computer Services, Inc. 1987 Stock Incentive Plan and Quantum Computer Services, Inc. Incentive Stock Option Plan (1985) and other option plans assumed by America Online (collectively, the "America Online Stock Option Plans") and (z) the 4% Convertible Subordinated Notes due November 15, 2002 of America Online and the Convertible Subordinated Notes due 2019 of America Online. Except in connection with new hire grants of America Online Stock Options made in a manner consistent with past practice to purchase, in the aggregate, not more than 100,000 shares of America Online Common Stock, Section 4.1(b) of the America Online Disclosure Schedule sets forth a complete and correct list, as of January 5, 2000, of the number of shares of America Online Common Stock subject to America Online Stock Options or other rights to purchase or receive America Online Common Stock granted under the America Online Benefit Plans or otherwise and the weighted average exercise price of the outstanding America Online Stock Options referenced therein. Except in connection with new hire grants of America Online Stock Options made in a manner consistent with past practice to purchase, in the aggregate, not more than 100,000 shares of America Online Common Stock, no options or warrants or other rights to acquire capital stock from America Online have been issued or granted since January 5, 2000 to the date of this Agreement. (ii) No bonds, debentures, notes or other indebtedness of America Online having the right to vote on any matters on which holders of capital stock of America Online may vote ("America Online Voting Debt") are issued or outstanding. (iii) Except as otherwise set forth in this Section 4.1(b) or in Section 4.1(b) of America Online Disclosure Schedule, as of the date of this Agreement, there are no securities, options, warrants, calls, rights, commitments, agreements, arrangements or undertakings of any kind to which America Online or any of its Subsidiaries is a party or by which any of them is bound obligating America Online or any of its Subsidiaries to issue, deliver or sell, or cause to be issued, delivered or sold, additional shares of capital stock or other voting securities of America Online or any of its Subsidiaries or obligating America Online or any of its Subsidiazies to issue, grant, extend or enter into any such security, option, warrant, call, right, commitment, agreement, arrangement or undertaking. Except as disclosed in Section 4.1(b) of the America Online Disclosure Statement, as of the date of this Agreement, there are no outstanding obligations of America Online or any of its Subsidiaries to repurchase, redeem or otherwise acquire any shares of capital stock of America Online or any of its Subsidiaries. (c) AuthoritX; No Conflicts. (i) America Online has all requisite corporate power and authority to enter into this Agreement and the Stock Option Agreements and to consummate the transactions contemplated hereby and thereby, subject in the case of the consummation of the America Online Merger to the adoption of this Agreement by the Required America Online Vote (as defined in ^v��;o0-OGi;7-02�69-:-�Cio�CN9-^Gr. lo Section 4.1(g)). The execution and delivery of this Agreement and the Stock Option Agreements and the consummation of the transactions contemplated hereby and thereby have been duly authorized by all necessary corporate action on the part of America Online and no other corporate proceedings on the part of America Online aze necessary to authorize the execution and delivery of this Agreement or to consummate the America Online Merger and the other transactions contemplated hereby, subject in the case of the consummation of the America Online Merger to the adoption of this Agreement by the Required America Online Vote. This Agreement and the Stock Option Agreements have been duly executed and delivered by America Online and constitute valid and binding agreements of America Online, enforceable against America Online in accordance with their respective terms, except as such enforceability may be limited by bankruptcy, insolvency, reorganization, moratorium and similar laws relating to or affecting creditors generally or by general equity principles (regardless of whether such enforceability is considered in a proceeding in equity or at law). (ii) The execution and delivery of this Agreement and the Stock Option Agreements by America Online do not, and the consummation by America Online of the America Online Merger and the other transactions contemplated hereby and thereby will not, conflict with, or result in any violation of, or constitute a default (with or without notice or lapse of time, or both) under, or give rise to a right of, or result by its terms in the, termination, amendment, cancellation or acceleration of any obligation or the loss of a material benefit under, or the creation of a Lien, charge, "put" or "call" right or other encumbrance on, or the loss of, any assets, including Intellectual Property (any such conflict, violation, default, right of termination, amendment, cancellation or acceleration, loss or creation, a"Violation") pursuant to: (A) any provision of the certificate of incorporation or bylaws or similar organizational document of America Online or any Significant Subsidiary of America Online, or (B) except (1) as, individually or in the aggregate, (2) would not reasonably be expected to have a Material Adverse Effect on America Online or would not prevent or materially delay the consummation of the Mergers, subject to obtaining or making the consents, approvals, orders, authorizations, registrations, declarations and filings referred to in paragraph (iii) below and except with respect to employee stock options and other awazds or (3) set forth in Section 4.1(c)(ii) of the America Online Disclosure Schedule, any loan or credit agreement, note, mortgage, bond, indenture, lease, benefit plan or other agreement, obligation, instrument, permit, concession, franchise, license, judgment, order, decree, statute, law, ordinance, rule or regulation applicable to America Online or any Subsidiary of America Online or their respective properties or assets. (iii) No consent, approval, order or authorization of, or registration, declaration or filing with, any supranational, national, state, municipal, local or foreign government, any instrumentality, subdivision, court, administrative agency or commission or other authority thereof, or any quasi-governmental or private body exercising any regulatory, taxing, importing or other governmental or quasi-governmental authority (a "Governmental Enti ") or any other Person, is required by or with respect to America Online o� any Subsidiary of America Online in connection with the execution and delivery of this Agreement and the Stock Option Agreements by America Online or the consummation of the America Online CC3'c�—CC07-02269—nC:8EC�9—M�A 19 Merger and the other transactions contemplated hereby and thereby, except for those required under or in relation to (A) the Hart-Scott-Rodino Antitrust Improvements Act of 1976, as amended (the "HSR Act"), Council Regulation No. 4064/89 of the European Community, as amended (the "EC Mer eg r Regulation"), the Competition Act (Canada) and the Investment Canada Act of 1985 (Canada) ("Canadian Investment Regulations"), (B) state securities or "blue sky" laws (the "Blue Sk,�Laws"), (C) the Securities Act of 1933, as amended (the "Securities Act"), (D) the Securities Exchange Act of 1934, as amended (the "Exchange Act"), (E) the DGCL with respect to the filing of the Certificates of Merger, (F) the rules and regulations of the NYSE, (G) antitrust or other competition laws of other jurisdictions, (H) the Communications Act of 1934, as amended, and the rules and regulations of the Federal Communications Commission or any successor entity (the "FCC") thereunder (the "Communications AcY'), (I) rules and regulations of (x) the cable franchising authorities having jurisdiction over the cable systems of Time Warner and its Subsidiaries and Affiliates (the "Franchising Authorities") and (y) the state public service commissions having jurisdiction over the assets of Time Wamer and its Subsidiaries and Affiliates ("PUCs") and (.n such consents, approvals, orders, authorizations, registrations, declarations and filings the failure of which to make or obtain, individually or in the aggregate, would not reasonably be expected to have a Material Adverse Effect on America Online. Consents, approvals, orders, authorizations, registrations, declarations and filings required under or in relation to any of the foregoing clauses (A) through (I) are hereinafter refened to as "Necessarv Consents". (d) Reports and Financial Statements. (i) America Online has filed all required registration statements, prospectuses, reports, schedules, forms, statements and other documents required to be filed by it with the SEC since July l, 1997 (collectively, including all e�chibits thereto, the "America Online SEC Reports"). Except as set forth in Section 4.1(d) of the America Online Disclosure Schedule, no Subsidiary of America Online is required to file any form, report, registration statement, prospectus or other document with the SEC. None of the America Online SEC Reports, as of their respective dates (and, if amended or superseded by a filing prior to the date of this Agreement, then on the date of such filing), contained or will contain any untrue statement of a material fact or omitted or will omit to state a material fact required to be stated therein or necessary to make the statements therein, in light of the circumstances under which they were made, not misleading. Each of the financial statements (including the related notes) included in the America Online SEC Reports presents fairly, in all material respects, the consolidated financial position and consolidated results of operations and cash flows of America Online and its consolidated Subsidiaries as of the respective dates or for the respective periods set forth therein, all in conformity with United States generally accepted accounting principles ("GAAP") consistently applied during the periods involved except as otherwise noted therein, and subject, in the case of the unaudited interim financial statements, to the absence of notes and normal yeaz- end adjustments that have not been and are not expected to be material in amour.t. All of such America Online SEC Reports, as of their respective dates (and as of the date of any amendment to the respective America Online SEC Report), complied as to form in all material respects with �p�; _�-^,pp7-C2269-A018ECn9-MGA 20 the applicable requirements of the Securities Act and the Exchange Act and the rules and regulations promulgated thereunder. (ii) Except as disclosed in the America Online SEC Reports filed and publicly available prior to the date hereof (the "America Online Filed SEC Re�orts"), America Online and its Subsidiaries have not incurred any liabilities that aze of a nature that would be required to be disclosed on a balance sheet of America Online and its Subsidiaries or the footnotes thereto prepazed in conformity with GAAP, other than (A) liabilities incurred in the ordinary course of business, (B) liabilities incurred in accordance with Section 5.1, (C) liabilities for Taxes (as defined in Section 4.1(m)) or (D) liabilities that, individually or in the aggregate, would not reasonably be expected to have a Material Adverse Effect on America Online. (e) Information Supplied. (i) None of the information supplied or to be supplied by America Online for inclusion or incorporation by reference in (A) the Form S-4 (as defined in Section 6.1) will, at the time the Form S-4 is filed with the SEC, at any time it is amended or supplemented or at the time it becomes effective under the Securities Act, contain any untrue statement of a material fact or omit to state any material fact required to be stated therein or necessary to make the statements therein, in light of the circumstances under which they were made, not misleading and (B) the Joint Proxy Statement/Prospectus (as defined in Section 6.1) will, on the date it is first mailed to Time Warner stockholders or America Online stockholders or at the time of the Time Warner Stockholders Meeting or the America Online Stockholders Meeting (each as defined in Section 6.1), contain any untrue statement of a material fact or omit to state any material fact required to be stated therein or necessary in order to make the statements therein, in light of the circumstances under which they were made, not misleading. The Form S-4 and the Joint Proxy StatementlProspectus will comply as to form in all material respects with the requirements of the Exchange Act and the Securities Act and the rules and regulations of the SEC thereunder. (ii) Notwithstanding the foregoing provisions of this Section 4.1(e), no representation or warranty is made by America Online with respect to statements made or incorporated by reference in the Form S-4 or the Joint Proxy Statement/Prospectus based on information supplied by Time Wamer for inclusion or incorporation by reference therein. ( fl Board Ap,� r� oval. The Board of Directors of America Online, by resolutions duly adopted by unanimous vote of those voting at a meeting duly called and held and not subsequently rescinded or modified in any way (the "America Online Board A�proval"), has duly (i) determined that this Agreement and the America Online Merger and the America Online Stock Option Agreement are fair to and in the best interests of America Online and its stockholders and declared the America Online Merger to be advisable, (ii) approved this Agreement, the America Online Stock Option Agreement, the Voting Agreemer.t, the America Online Merger, and (iii) recommended that the stockholders of America Online adopt this Agreement and directed that such matter be submitted for consideration by America Online's CO3i50-0007-02265-AOla_�lo_uG:. 21 stockholders at the America Online Stockholders Meeting. The America Online Board Approval constitutes approval of this Agreement, the America Online Stock Option Agreement and the America Online Merger for purposes of Section 203 of the DGCL and Article EIGHTH of the Restated Certificate of Incorporation of America Online. To the knowledge of America Online, except for Section 203 of the DGCL (which has been rendered inapplicable), no state takeover statute is applicable to this Agreement, the America Online Stock Option Agreement or the America Online Merger or the other transactions contemplated hereby or thereby. (g) Vote Re�uired. The affumative vote of the holders of a majority of the outstanding shares of America Online Common Stock to adopt this Agreement (the "Required America Online Vote") is the only vote of the holders of any class or series of America Online capital stock necessary to approve or adopt this Agreement, the America Online Stock Option Agreement and the America Online Merger and to consummate the America Online Merger and the other transactions contemplated hereby and thereby. (h) Litigation: Com�liance with Laws. (i) There are no suits, actions, judgments or proceedings (collectively, "Actions") pending or, to the knowledge of America Online, threatened, against or affecting America Online or any Subsidiary of America Online or any property or asset of America Online or any Subsidiary of America Online which, individually or in the aggregate, would reasonably be expected to have a Material Adverse Effect on America Online, nor are there any judgments, decrees, injunctions, rules or orders of any Governmental Entity or arbitrator outstanding against America Online or any Subsidiary of America Online which, individually or in the aggregate, would reasonably be expected to have a Material Adverse Effect on America Online. (ii) Except as, individually or in the aggregate, would not reasonably be expected to have a Material Adverse Effect on America Online, America Online and its Subsidiaries hold all permits, licenses, franchises, variances, exemptions, orders and approvals of all Governmental Entities which are necessary for the operation of the businesses as now being conducted of America Online and its Subsidiaries, taken as a whole (the "America Online Permits"), and no suspension or cancellation of any of the America Online Permits is pending or, to the knowledge of America Online, threatened. America Online and its Subsidiaries are in compliance with the terms of the America Online Permits, except where the failure to so comply, individually or in the aggregate, would not reasonably be expected to have a Material Adverse Effect on America Online. Neither America Online nor its Subsidiaries is in violation of, and America Online and its Subsidiaries have not received any notices of violations with respect to, any laws, statutes, ordinances, rules or regulations of any Governmental Entity, except for violations which, individually or in the aggregate, would not reasonably be expected to have a Material Adverse Effect on America Online. (i) Absence of Certain Chan�es or Events. Except as disclosed in Section 4.1(i) of the America Online Disclosure Schedule and for liabilities permitted to be incurred in C037S0-�007-�2269-n0:6ECF.9-",�?. 22 accordance with this Agreement or the transactions contemplated hereby, since September 30, 1999, America Online and its Subsidiaries have conducted their business only in the ordinary course and in a manner consistent with past practice and, since December 31, 1998, there have not been any changes, circumstances or events which, individually or in the aggregate, have had, or would reasonably be expected to have, a Material Adverse Effect on America Online. (j) Intellectual Propertv: Year 2000. (i) Except as would not, individually or in the aggregate, reasonably be expected to have a Material Adverse Effect on America Online: (a) America Online and each of its Subsidiaries owns, or is licensed to use (in each case, free and clear of any Liens), all Intellectual Property (as defined below) used in or necessary for the conduct of its business as cunently conducted; (b) to the knowledge of America Online, the use of any Intellectual Property by America Online and its Subsidiaries does not infringe on or otherwise violate the rights of any Person, (c) the use of the Intellectual Property is in accordance with applicable licenses pursuant to which America Online or any Subsidiary acquired the right to use any Intellectual Property; and (d) to the knowledge of America Online, no Person is challenging, infringing on or otherwise violating any right of America Online or any of its Subsidiaries with respect to any Intellectual Properry owned by and/or licensed to America Online or its Subsidiaries. As of the date of this Agreement, except as would not reasonably be expected, individually or in the aggregate, to have a Material Adverse Effect on America Online, neither America Online nor any of its Subsidiaries has knowledge of any pending claim, order or proceeding with respect to any Intellectual Property used by America Online and its Subsidiaries and to its knowledge no Intellectual Property owned and/or licensed by America Online or its Subsidiaries is being used or enforced in a manner that would reasonably be expected to result in the abandonment, cancellation or unenforceability of such Intellectual Property. For purposes of this Agreement, "Intellectual Pro e" shall mean trademarks, service marks, brand names, certification marks, trade dress and other indications of origin, the goodwill associated with the foregoing and registrations in any jurisdiction of, and applications in any jurisdiction to register, the foregoing, including any extension, modification or renewal of any such registration or application; inventions, discoveries and ideas, whether patentable or not, in any jurisdiction; patents, applications for patents (including, without limitation, divisions, continuations, continuations in part and renewal applications), and any renewals, extensions or reissues thereof, in any jurisdiction; nonpublic information, trade secrets and confidential information and rights in any jurisdiction to limit the use or disclosure thereof by any person; writings and other works, whether copyrightable or not, in any jurisdiction; and registrations or applications for registration of copyrights in any jurisdiction, and any renewals or extensions thereof any similar intellectual properiy or proprietary rights. (ii) Prior to the date of this Agreement, America Online and its Subsidiaries have undertaken a concerted effort to ensure that all of the computer software, computer firm�vare, computer hardware, and other similar or related items of automated, computerized, and/or software system(s) that are used or relied on by America Online or any or its Subsidiaries 00378C-000?-02269-A018ECH9-N.G:+ 23 in the conduct of their respective businesses will not malfunction, will not cease to function, will not generate incorrect data, and will not provide incorrect results when processing, providing and/or receiving (a) date-related data into and between the years 1999 and 2000 and (b) date- related data in connection with any valid date in the twentieth and twenty-first centuries. As of the date of this Agreement, except as would not reasonably be expected, individually or in the aggregate, America Online reasonably believes that such effort will be successful. (k) Brokers or Finders. No agent, broker, investment banker, fmancial advisor or other firm or Person is or will be entitled to any broker's or finder's fee or any other similar commission or fee in connection with any of the transactions contemplated by this Agreement based upon arrangements made by or on behalf of America Online, except Salomon Smith Barney, Inc., whose fees and expenses will be paid by America Online. (1) O_pinion of America Online Financial Advisor. America Online has received the opinion of Salomon Smith Barney, Inc., dated the date of this Agreement, to the effect that, as of such date, the Exchange Ratio is fair to America Online, from a financial point of view, a copy of which opinion will be made available to Time Warner promptly after the date of this Agreement. (m} Taxes. Each of America Online and its Subsidiaries has filed all Tax Returns required to have been filed (or extensions have been duly obtained) and has paid all Taxes required to have been paid by it, except where failure to file such Tax Returns or pay such Taxes would not, individually or in the aggregate, reasonably be expected to have a Material Adverse Effect on America Online. For purposes of this Agreement: (i) "Tax" (and, with correlative meaning, "Taxes") means any federal, state, local or foreign income, gross receipts, property, sales, use, license, excise, franchise, employment, payroll, withholding, alternative or add on minimum, ad valorem, transfer or excise tax, or any other tax, custom, duty, governmental fee or other like assessment or chazge of any kind whatsoever, together with any interest or penalty, imposed by any governmental authority or any obligation to pay Taxes imposed on any entity for which a party to this Agreement is liable as a result of any indemnification provision or other contractual obligation, and (ii) "Tax Return" means any return, report or similar statement required to be filed with respect to any Tax (including any attached schedules), including, without limitation, any information return, claim for refund, amended return or declaration of estimated Tax. Neither America Online nor any of its Subsidiaries has taken any action or laiows of any fact that is reasonably likely to prevent the Mergers from qualifying as exchanges within the meaning of Section 351 of the Code and as reorganizations within the meaning of Section 368(a) of the Code. (n) Certain Contracts. As of the date hereof, except as disclosed in Section 4.1(n} of the America Online Disclosure Schedule, neither America Online nor any of its Subsidiaries is a party to or bound by (i) any "material contracts" (as such term is defined in Item 003�80-000'r-02269-AC�6ECH9-M�?. 24 6U1(b)(10) of Regulation S-K of the SEC) with respect to America Online and its Subsidiaries or (ii) any material agreement that restricts the ability of America Online or Time Warner or any of their Subsidiaries or affiliates to distribute, promote, market or otherwise offer Internet and interactive services, Internet and interactive programming, or Internet and interactive functionality on the cable systems owned by Time Warner or its Subsidiaries or affiliates (collectively, "America Online Internet Restrictioas"). All contracts described in clause (i) aze valid and in full force and effect except to the extent they have previously expired in accordance with their terms or if the failure to be in full force and effect, individually or in the aggregate, would not reasonably be expected to have a Material Adverse Effect on America Online. Neither America Online nor any of its Subsidiaries has violated any provision of, or committed or failed to perform any act which with or without notice, lapse of time or both would constitute a default under the provisions of, any contract described in clause (i), except in each case for those violations and defaults which, individually or in the aggregate, would not reasonably be expected to result in a Material Adverse Effect on America Online. (o) America Online Stockholder Ri�hts Plan. The Board of Directors of America Online has amended the America Online Rights Agreement in accordance with its terms to render it inapplicable to the transactions contemplated by this Agreement and the America Online Stock Option Agreement. (p) Emplovee Benefits. (i) The Benefit Plans, whether oral or written, under which any current or former employee or director of America Online or its Subsidiaries has any present or future right to benefits contributed to, sponsored by or maintained by America Online or its Subsidiaries, or under which America Online or its Subsidiaries has any present or future liability shall be collectively referred to as the "America Online Benefit Plans." (ii) Except as set forth in Section 4.1(p) of the America Online Disclosure Schedule, with respect to each America Online Benefit Plan, no liability has been incurred and there exists no condition or circumstances in connection with which America Online or any of its Subsidiaries could be subject to any liability that is reasonably likely, individually or in the aggregate, to have a Material Adverse Effect on America Online, in each case under ERISA (as defined in Section 9.11(b)}, the Code, or any other applicable law, rule or regulation. (iii) America Online and its Subsidiaries aze in compliance with all Federal, state, local and foreign requirements regarding employment, except for any failures to comply that are not reasonably likely, individually or in the aggregate, to have a Material Adverse Effect on America Online. As of the date of this Agreement, there is no labor dispute, strike or work stoppage against America Online or any of its Subsidiaries pending or, to the knowledge of America Online, threatened which may interfere with the business activities of America Online or any of its Subsidiaries, except where such dispute, strike or work stoppage is not reasonably likely, individually or in the aggregate, to have a Material Adverse Effect on America Online. cc�;sc-oco�-ozzo�-r,�:sec-4-v�� 25 4.2 Representations and Warranties of Time Warner. Except as disclosed in the Time Warner Filed SEC Reports (as defined in Section 4.2(d)(ii)) or as set forth in the Time Warner Disclosure Schedule delivered by Time Warner to America Online prior to the execution of this Agreement (the "Time Warner Disclosure Schedule"), Time Warner represents and warrants to America Online as follows: (a) Or,ganization. Standing and Power; Subsidiaries. (i) Each of Time Warner and each of its Subsidiaries is a corporation or other organization duly organized, validly existing and in good standing under the laws of its jurisdiction of incorporation or organization, has the requisite power and authority to own, lease and operate its properties and to carry on its business as now being conducted, except where the failure to be so organized, existing and in good standing or to have such power and authority, individually or in the aggregate, would not reasonably be expected to have a Material Adverse Effect on Time Wamer, and is duly qualified and in good standing to do business in each jurisdiction in which the nature of its business or the ownership or leasing of its properties makes such qualification necessary other than in such jurisdictions where the failure so to qualify or to be in good standing, individually or in the aggregate, would not reasonably be expected to have a Material Adverse Effect on Time Warner. The copies of the certificate of incorporation and bylaws of Time Warner which were previously furnished or made available to America Online are true, complete and correct copies of such documents as in effect on the date of this Agreement and the copy of the Agreement of Limited Partnership, dated as of October 29, 1991, as amended, of Time Warner Entertainment Company, L.P. ("TWE") which was previously furnished to America Online is a true, complete and correct copy of such agreement as in effect on the date of this Agreement (the "TWE Partnership A�reement"). (ii) Exhibit 21 to Time Warner's Annual Report on Form 10-K for the yeaz ended December 31, 1998 includes all the Subsidiaries of Time Warner which as of the date of this Agreement are Significant Subsidiaries (as defined in Rule 1-02 of Regulation S-X of the SEC and including TWE). All the outstanding shares of capital stock of, or other equity interests in, each such Significant Subsidiary have been validly issued and are fully paid and nonassessable and are, except as set forth in such Exhibit 21 and in the TWE Partnership Agreement, owned directly or indirectly by Time Wamer, free and clear of all Liens and free of any other restriction (including any restriction on the right to vote, sell or otherwise dispose of such capital stock or other ownership interests), except for restrictions imposed by applicable securities laws. As of the date of this Agreement, neither Time Warner nor any of its Subsidiaries directly or indirectly owns any equity or similar interest in, or any interest convertible into or exchangeable or exercisable for, any corporation, partnership, joint venture or other business association or entity (other than Subsidiaries), that is or would reasonably be expected to be material to Time Warner and its Subsidiaries taken as a whole. oo;,ac-cco�-cz2�5-nciaecx9-r,c:, 26 Time Warner indirectly owns a 74.49% priority capital and residual equity interest in TWE as described in the TWE Partnership Agreement, free and clear of all Liens (except under the TWE Partnership Agreement). (b) Capital Structure. (i) As of November 30, 1999, the authorized capital stock of Time Warner consists of (a) 5,000,000,000 shares of Time Warner Common Stock of which 1,172,176,909 shazes were outstanding, (B) 600,000,000 shares of Series Common Stock, par value $.O1 per share, of which (1) 140,000,000 shares have been designated as Time Warner Series LMC Common Stock, of which no shares are outstanding and (2) 140,000,000 shazes have been designated as Time Warner Series LMCN-V Common Stock, of which 114,123,884 shares are outstanding, and (C) 250,000,000 shares of preferred stock, par value $.10 per share, of which (1) 8,000,000 shares have been designated Series A Participating Cumulative Preferred Stock and reserved for issuance upon exercise of the rights (the "Time Wamer Rights") distributed to holders of Time Warner Common Stock pursuant to the Rights Agreement, dated as of October 10, 1996 between Time Warner and ChaseMellon Shareholder Services, LLC, as Rights Agent, as amended (together with any substitute rights agreement entered into pursuant to Section 6.10(b), the "Time Warner Ri ng ts Agreement"), (2) 11,000,000 shares have been designated Series D Convertible Preferred Stock, of which no shares are outstanding, (3) 3,250,000 shares have been designated Series E Convertible Preferred Stock, of which 3,129,251 shares are outstanding, (4) 3,100,000 shazes have been designated Series F Convertible Preferred Stock, of which 2,965,761 shares are outstanding, (5) 7,000,000 shares 'have been designated Series I Convertible Preferred Stock, of which 700,000 shares are outstanding and (6) 3,350,000 shares have been designated Series J Convertible Preferred Stock, of which 1,608,708 shares aze outstanding. Since November 30, 1999 to the date of this Agreement, there have been no issuances of shares of the capital stock of Time Warner or any other securities of Time Warner other than issuances of shares pursuant to outstanding convertible securities or options or rights outstanding as of November 30, 1999 and 59,250 Time Warner Restricted Shares under the Benefit Plans of Time Warner, and pursuant to the Time Warner Dividend Reinvestment and Stock Purchase Plan. All issued and outstanding shares of the capital stock of Time Wamer are duly authorized, validly issued, fully paid and nonassessable, and free of any preemptive rights. All accrued dividends that were payable on Time Wamer Preferred Stock have been paid. There were outstanding as of December 31, 1999 no options, warrants or other rights to acquire capital stock from Time Warner other than (x) the Time Warner Rights and (y) approximately 135,867,893 Time Warner Stock Options (as defined in the next sentence) and 82,000 Time Warner Restricted Shares. The options and other rights to acquire Time Warner Common Stock from Time Warner representing the right to purchase shares of Time Warner Common Stock, together with other employee stock options issued by Time Warner after the date hereof in accordance with the Time Warner Stock Option Plans (as defined in the next sentence) and Section 5.2, aze referred to herein collectively as the "Time Warner Stock Options"). The Time Warner Stock Options and the Time Warner Restricted Shares have been and will be granted under the Time Warner 1986 Stock Option Plan, the 1988 0.^i3 �60-�0^v i-�2269-nG<6ECn5-:�;Gn 27 Stock Incentive Plan of Time Warner Inc., Time Warner 1989 Stock Incentive Plan, Time Warner 1994 Stock Option Plan, Time Warner Corporate Group Stock Incentive Plan, Time Warner 1997 Stock Option Plan, Time Warner 1996 Stock Option Plan for Non-Employee Directors, Time Warner 1989 WCI Replacement Stock Option Plan, 1989 Lorimar Non- Employee Replacement Stock Option Plan, Time Warner 1993 Stock Option Plan, Time Wamer Filmed Entertainment Group Stock Incentive Plan, Time Warner Music Group Stock Incentive Plan, Time Warner Programming Group Stock Incentive Plan, Time Warner Publishing Group Stock Incentive Plan, Time Warner Cable Group Stock Incentive Plan, Subsidiary 1988 Stock Option Plan, Subsidiary 1993 Stock Option and Equity-Based Awazd Plan, Subsidiary 1986 Stock Option Plan, Subsidiary 1990 Stock Option Plan, Subsidiary 1991 Stock Option Plan and Subsidiary Nonqualified Stock Option Agreements, the Time Warner 1999 Restricted Stock Plan, the Time Warner 1988 Restricted Stock Plan for Non-Employee Directors and the Time Warner 1999 Intemational Employees Restricted Stock Plan (collectively, the "Time Warner Stock Option Plans"). Except in connection with pre-employment grants of Time Warner Stock Options made in a manner consistent with past practice to purchase, in the aggregate, not more than 100,000 shares of Time Warner Common Stock, Section 4.2(b)(i) of the Time Warner Disclosure Schedule sets forth a complete and correct list, as of December 31, 1999, of the number of shares of Time Warner Common Stock subject to Time Warner Stock Options or other rights to purchase or receive Time Warner Common Stock granted under the Time Warner Benefit Plans or otherwise and the weighted average exercise price of the outstanding Time Wamer Stock Options referenced therein. Except in connection with pre-employment grants of Time Warner Stock Options made in a manner consistent with past practice to purchase, in the aggregate, not more than 100,000 shares of Time Warner Common Stock, no options or warrants or other rights to acquire capital stock from Time Warner have been issued or granted since December 31, 1999 to the date of this Agreement. (ii) No bonds, debentures, notes or other indebtedness of Time Warner having the right to vote on any matters on which holders of capital stock of Time Warner may vote ("Time Warner Voting�,Debt") are issued or outstanding. (iii) Except as otherwise set forth in this Section 4.2(b) or in Section 4.2(b)(iii) of the Time Warner Disclosure Schedule, as of the date of this Agreement, there aze no securities, options, warrants, calls, rights, commitments, agreements, arrangements or undertakings of any kind to which Time Warner or any of its Subsidiaries is a party or by which any of them is bound obligating Time Wamer or any of its Subsidiaries to issue, deliver or sell, or cause to be issued, delivered or sold, additional shares of capital stock or other voting securities of Time Warner or any of its Subsidiaries or obligating Time Warner or any of its Subsidiaries to issue, grant, extend or enter into any such security, option, warrant, call, right, commitment, agreement, arrangement or undertaking. As of the date of this Agreement, there are no outstanding obligations of Time Warner or any of its Subsidiaries to repurchase, redeem or otherwise acquire any shares of capital stock of Time Warner or any of its Subsidiaries. �J3', 55-�u07-02269-A016cCn9-."^.GA 28 (c) Authoritv: No Conflicts. (i) Time Warner has all requisite corporate power and authority to enter into this Agreement and the Stock Option Agreements and to consummate the transactions contemplated hereby and thereby, subject in the case of the consummation of the Time Warner Merger to the adoption of this Agreement by the Required Time Wamer Vote (as defined in Section 4.2(g)). The execution and delivery of this Agreement and the Stock Option Agreements and the consummation of the transactions contemplated hereby and thereby have been duly authorized by all necessary corporate action on the part of Time Warner and no other corporate proceedings on the part of Time Warner are necessary to authorize the execution and delivery of the Agreement or to consummate the Time Warner Merger and the other transactions contemplated hereby, subject in the case of the consummation of the Time Warner Merger to the adoption of this Agreement by the Required Time Wamer Vote. This Agreement and the Stock Option Agreements have been duly executed and delivered by Time Warner and constitute valid and binding agreements of Time Warner, enforceable against Time Warner in accordance with their respective terms, except as such enforceability may be limited by bankruptcy, insolvency, reorganization, moratorium and similar laws relating to or affecting creditors generally or by general equity principles (regardless of whether such enforceability is considered in a proceeding in equity or at law). (ii) The execution and delivery of this Agreement and the Stock Option Agreements by Time Warner do not, and the consummation by Time Warner of the Time Warner Merger and the other transactions contemplated hereby and thereby will not, conflict with, or result in a Violation pursuant to: (A) any provision of the certificate of incorporation or bylaws or similar organizational document of Time Warner or any Significant Subsidiary of Time Warner (including the TWE Partnership Agreement) or (B) except (1) as, individually or in the aggregate, would not reasonably be expecte°d to have a Material Adverse Effect on Time Wamer or (2) would not prevent or materially delay the consummation of the Mergers, subject to obtaining or making the consents, approvals, orders, authorizations, registrations, declarations and filings referred to in paragraph (iii) below or (3) set forth in Section 4.2(c)(ii) of the Time Warner Disclosure Schedule and except with respect to employee stock options and other awards, any loan or credit agreement, note, mortgage, bond, indenture, lease, benefit plan or other agreement, obligation, instrument, permit, concession, franchise, license, judgment, order, decree, statute, law, ordinance, rule or regulation applicable to Time Warner or any Subsidiary of Time Warner or their respective properties or assets. (iii) No consent, approval, order or authorization of, or registration, declaration or filing with, any Governmental Entity or any other Person is required by or with respect to Time Warner or any Subsidiary of Time Wamer in connection with the execution and delivery of this Agreement and the Stock Option Agreements by Time Warner or the consummation of the Time Wamer Merger and the other transactions contemplated hereby and thereby, except the Necessary Consents and such consents, approvals, orders, authorizations, registrations, declarations and filings the failure of which to make or obtain, individually or in OC�;9v-G007-02269-AOi6cCFi9-'Y,Gn 29 the aggregate, would not reasonably be expected to have a Material Adverse Effect on Time Warner. (d) Reports and Financial Statements. (i) Each of Time Warner and TWE have filed all required registration statements, prospectuses, reportsx schedules, forms, statements and other documents required to be filed by each of them with the SEC since December 31, 1996 (collectively, including all exhibits thereto, the "Time Warner SEC Reports"). Except as set forth in Section 4.2(d)(i) of the Time Warner Disclosure Schedule, no Subsidiary of Time Warner is required to file any form, report, registration statement, prospectus or other document with the SEC. None of the Time Warner SEC Reports, as of their respective dates (and, if amended or superseded by a filing prior to the date of this Agreement, then on the date of such filing), contained or will contain any untrue statement of a material fact or omitted or will omit to state a material fact required to be stated therein or necessary to make the statements therein, in light of the circumstances under which they were made, not misleading. Each of the financial statements (including the related notes) included in the Time Warner SEC Reports presents fairly, in all material respects, the consolidated financial position and consolidated results of operations and cash flows of Time Warner or TWE, as the case may be, and its consolidated Subsidiaries as of the respective dates or for the respective periods set forth therein, all in conformity with GAAP consistently applied during the periods involved except as otherwise noted therein, and subject, in the case of the unaudited interim financial statements, to the absence of notes and normal year-end adjustments that have not been and are not expected to be material in amount. All of such Time Warner SEC Reports, as of their respective dates (and as of the date of any amendment to the respective Time Warner SEC Report), complied as to form in all material respects with the applicable requirements of the Securities Act and the Exchange Act and the rules and regulations promulgated thereunder. (ii) Except as disclosed in the Time Warner SEC Reports filed and publicly available prior to the date hereof (the "Time Warner Filed SEC Reports"), Time Warner and its Subsidiaries have not incurred any liabilities that are of a nature that would be required to be disclosed on a balance sheet of Time Warner and its Subsidiaries or the footnotes thereto prepared in conformity with GAAP, other than (A) liabilities incurred in the ordinary course of business, (B) liabilities incurred in accordance with Section 5.2, (C) liabilities for Taxes or (D) liahilities that, individually or in the aggregate, would not reasonably be expected to have a Material Adverse Effect on Time Warner. (e) Information Sup�lied. (i) None of the information supplied or to be supplied by Time Warner for inclusion or incorporation by reference in (A) the Form S-4 will, at the time the rorm S-4 is filed with the SEC, at any time it is amended or supplemented or at the time it becomes effective under the Securities Act, contain any untrue statement of a material fact or omit to state any cc�,-c-oco�-ozzES-�o_aecrs-4�� 30 � material fact required to be stated therein or necessary to make the statements therein, in light of the circumstances under which they were made, not misleading, and (B) the Joint Proxy StatementlProspectus will, on the date it is first mailed to Time Warner stockholders or America Online stockholders or at the time of the Time Warner Stockholders Meeting or the America Online Stockholders Meeting, contain any untrue statement of a material fact or omit to state any material fact required to be stated therein or necessary in order to make the statements therein, in light of the circumstances under which they were made, not misleading. The Form S-4 and the Joint Proxy Statement/Prospectus will comply as to form in all material respects with the requirements of the Exchange Act and the Securities Act and the rules and regulations of the SEC thereunder. (ii) Notwithstanding the foregoing provisions of this Section 42(e), no representation or warranty is made by Time Warner with respect to statements made or incorporated by reference in the Form S-4 or the Joint Proxy Statement/Prospectus based on information supplied by America Online for inclusion or incorporation by reference therein. ( fl Board Ap�roval. The Board of Directors of Time Warner, by resolutions duly adopted by unanimous vote of those voting at a meeting duly called and held and not subsequently rescinded or modified in any way (the "Time Warner Board A�, nroval"), has duly (i) determined that this Agreement and the Time Wamer Merger and the Time Warner Stock Option Agreement are fair to and in the best interests of Time Warner and its stockholders and declared the Time Warner Merger to be advisable, (ii) approved this Agreement, the Time Warner Stock Option Agreement, the Voting Agreement and the Time Wamer Merger and (iii) recommended that the stockholders of Time Warner adopt this Agreement and d'uected that such matter be submitted for consideration by Time Warner's stockholders at the Time Warner Stockholders Meeting. The Time Warner Board Approval constitutes approval of this Agreement, the Time Warner Stock Option Agreement, the Voting Agreement and the Time Warner Merger for purposes of Section 203 of the DGCL and Article V of the Restated Certificate of Incorporation of Time Warner. To the knowledge of Time Warner, except for Section 203 of the DGCL (which has been rendered inapplicable), no state takeover statute is applicable to this Agreement, the Time Warner Stock Option Agreement, the Voting Agreement or the Time Warner Merger or the other transactions contemplated hereby or thereby. (g) Vote Required. The affirmative vote of the holders of a majority of the voting power of the outstanding shares of Time Warner Series LMC Common Stock, Time Warner Common Stock and Time Warner Preferred Stock, voting together as a single class, to adopt this Agreement (the "Required Time Warner Vote") is the only vote of the holders of any class or series of Time Warner capital stock necessary to approve or adopt this Agreement, the Time Wamer Stock Option Agreement and the Time Warner Merger and to consummate the Time Warner Merger and the other transactions contemplated hereby and thereby. OC3'eJ-0007-02269-AC:BEC'r.9_:!G�l 31 (h) Liti�ation: Compliance with Laws. (i) There are no Actions pending or, to the knowledge of Time Warner, threatened, against or affecting Time Warner or any Subsidiary of Time Warner or any property or asset of Time Warner or any Subsidiary of Time Warner which, individually or in the aggregate, would reasonably be expected to have a Material Adverse Effect on Time Warner, nor are there any judgments, decrees, injunctions, rules or orders of any Governmental Entity or arbitrator outstanding against Time Warner or any Subsidiary of Time Warner which, individually or in the aggregate, would reasonably be expected to have a Material Adverse Effect on Time Wamer. (ii) Except as individually or in the aggregate would not reasonably be expected to have a Material Adverse Effect on Time Warner, Time Warner and its Subsidiaries hold all permits, licenses, franchises, variances, exemptions, orders and approvals of all Governmental Entities which are necessary for the operation of the businesses as now being conducted of Time Warner and its Subsidiaries, taken as a whole (the "Time Warner Pennits"), and no suspension or cancellation of any of the Time Warner Permits is pending or, to the knowledge of Time Wamer, threatened. Time Warner and its Subsidiaries aze in compliance with the terms of the Time Warner Permits, except where the failure to so comply, individually or in the aggregate, would not reasonably be expected to have a Material Adverse Effect on Time Warner. Neither Time Warner nor its Subsidiaries is in violation of, and Time Warner and its Subsidiaries have not received any notices of violations with respect to, any laws, statutes, ordinances, rules or regulations of any Governmental Entity, except for violations which, individually or in the aggregate, would not reasonably be expected to have a Material Adverse Effect on Time Warner. (i) At sence of CertaimChanges or Events. Except as disclosed in Section 4.2(i) of the Time Wamer Disclosure Schedule and for liabilities permitted to be incurred in accordance with this Agreement or the transactions contemplated hereby, since September 30, 1999, Time Warner and its Subsidiaries have conducted their business only in the ordinary course and in a manner consistent with past practice and, since December 31, 1998, there have not been any changes, circumstances or events which, individually or in the aggregate, have had, or would reasonably be expected to have, a Material Adverse Effect on Time Warner. (j) Intellectual Property; Year 2000. (i) Except as would not, individually or in the aggregate, reasonably be expected to have a Material Adverse Effect on Time Warner: (a) Time Warner and each of its Subsidiaries owns, or is licensed to use (in each case, free and clear of any Liens), all Intellectual Property used in or necessary for the conduct of its business as currently conducted; (b) to the knowledge of Time Wamer, the use of any Intellectual Property by Time Warner and its Subsidiaries does not infringe on or otherwise violate the rights of any Person, (c) the use of the Intellectual Property is in accordance with applicable licenses pursuant to which Time Wamer or CO.i?30-OOC7-022o9-i.,^,? EcCri9-h:G�, 32 any Subsidiary acquired the right to use any Intellectual Property; and (d) to the knowledge of Time Warner, no Person is challenging, infringing on or otherwise violating any right of Time Warner or any of its Subsidiaries with respect to any Intellectual Property owned by andlor licensed to Time Warner or its Subsidiaries. As of the date of this Agreement, except as would not reasonably be expected, individually or in the aggregate, to have a Material Adverse Effect on Time Warner, neither Time Warner nor any of its Subsidiaries has lmowledge of any pending claim, order or proceeding with respect to any Intellectual Property used by Time Warner and its Subsidiaries and to its knowledge no Intellectual Properiy owned and/or licensed by Time Wamer or its Subsidiaries is being used or enforced in a manner that would reasonably be expected to result in the abandonment, cancellation or unenforceability of such Intellectual Property. (ii) Prior to the date of this Agreement, Time Warner and its Subsidiaries have undertaken a concerted effort to ensure that all of the computer software, computer firmware, computer haxdware, and other similar or related items of automated, computerized, andlor software system(s) that are used or relied on by Time Warner or any or its Subsidiaries in the conduct of their respective businesses will not malfunction, will not cease to function, will not generate incorrect data, and will not provide incorrect results when processing, providing and/or receiving (a) date-related data into and between the years 1999 and 2000 and (b) date- related data in connection with any valid date in the twentieth and twenty-first centuries. As of the date of this Agreement, except as would not reasonably be expected, individually or in the aggregate, to have a Material Adverse Effect on Time Warner, Time Warner reasonably believes that such effort will be successful. (k) Brokers or Finders. No agent, broker, investment banker, financial advisor or other firm or Person is or will be entitled to any broker's or finder's fee or any other similar commission or fee in connection with any of the transactions contemplated by this Agreement, based upon arrangements made by or on behalf of Time Warner except Morgan Stanley Dean Witter & Co. Incorporated, whose fees and expenses will be paid by Time Warner. (1) Opinion of Time Warner Financial Advisor. Time Warner has received the opinion of Morgan Stanley Dean Witter & Co. Incorporated, dated the date of this Agreement, to the effect that, as of such date, the Exchange Ratio is fair, from a financial point of view, to the holders of Time Warner Common Stock and Time Warner Series Common Stock, a copy of which opinion will be made available to America Online promptly after the date of this Agreement. (m) Taxes. Each of Time Warner and its Subsidiaries has filed all Tax Returns required to have been filed (or extensions have been duly obtained) and has paid all Taxes required to have been paid by it, except where failure to file such Tax Retums or pay such Taxes would not, individually or in the aggregate, reasonably be expected to have a Material Adverse Effect on Time Warner. C03730-COC7-C2269-A018:C'r.9-KGF 33 Neither Time Warner nor any of its Subsidiaries has taken any action or knows of any fact that is reasonably likely to prevent the Mergers from qualifying as exchanges within the meaning of Section 351 of the Code and as reorganizations within the meaning of Section 368(a) of the Code. (n) Certain Contracts. As of the date hereof, except as disclosed in Section 4.2(n) of the Time Warner Disclosure Schedule, neither Time Warner nor any of its Subsidiaries is a party to or bound by (i) any "material contracts" (as such term is defined in Item 601(b)(10) of Regulation S-K of the SEC) with respect to Time Warner and its Subsidiaries or (ii) any material agreement that restricts the ability of America Online or Time Warner or any of their Subsidiaries or affiliates to distribute, promote, market or otherwise offer Internet and interactive services, Internet and interactive programming, or Internet and interactive functionality on the cable systems owned by Time Warner or its Subsidiaries or affiliates (collectively, "Time Warner Internet Restrictions"). All contracts described in clause (i) are valid and in full force and effect except to the extent they have previously expired in accordance with their terms or if the failure to be in full force and effect, individually or in the aggregate, would not reasonably be expected to have a Material Adverse Effect on Time Warner. Neither Time Warner nor any of its Subsidiaries has violated any provision of, or committed or failed to perForm any act which with or without notice, lapse of time or both would constitute a default under the provisions of, any contract described in clause (i), except in each case for those violations and defaults which, individually or in the aggregate, would not reasonably be expected to result in a Material Adverse Effect on Time Warner. (o) Time Warner Stockholder Rights Plan. The Board of Directors of Time Warner has amended the Time Warner Rights Agreement in accordance with its terms to render it inapplicable to the transactions contemplated by this Agreement and the Time Warner Stock Option Agreement. (p) Emplovee Benefits. (i) The Benefit Plans, whether oral or written, under which any current or former employee or director of Time Warner or its Subsidiaries has any present or future right to benefits contributed to, sponsored by or maintained by Time Wamer or its Subsidiaries, or under which Time Warner or its Subsidiaries has any present or future liability shall be collectively referred to as the "Time Warner Benefit Plans." (ii) With respect to each Time Wamer Benefit Plan, no liability has been incurred and there exists no condition or circumstances in connection with which Time Warner or any of its Subsidiaries could be subject to any liability that is reasonably likely, individually or in the aggregate, to have a Material Adverse Effect on Time Warner, in each case under ERISA, the Code, or any other applicable law, rule or regulation. C�37"eC—vCO3—G2269—:+016EC;:9-v��. 34 (iii} Time Warner and its Subsidiaries are in compliance with all Federal, state, local and foreign requirements regarding employment, except for any failures to comply that are not reasonably likely, individually or in the aggregate, to have a Material Adverse Effect on Time Warner. As of the date of this Agreement, there is no labor dispute, strike or work stoppage against Time Warner or any of its Sub�idiaries pending or, to the knowledge of Time Warner, threatened which may interfere with the business activities of Time Warner or any of its Subsidiaries, except where such dispute, strike or work stoppage is not reasonably likely, individually or in the aggregate, to have a Material Adverse Effect on Time Warner. ARTICLE V COVENANTS RELATING TO CONDUCT OF BUSINESS 5.1 Covenants of America Online. During the period from the date of this Agreement and continuing until the Effective Time, America Online agrees as to itself and its Subsidiaries that (except as expressly contemplated or permitted by this Agreement, the Stock Option Agreements or Section 5.1 (including its subsections) of the America Online Disclosure Schedule or as required by a Governmental Entity or to the extent that Time Warner shall otherwise consent in writing, which consent shall not be unreasonably withheld or delayed): (a) Ordinarv Course. (i) America Online and its Subsidiaries shall carry on their respective businesses in the usual, regular and ordinary course in all material respects, in substantially the same manner as heretofore conducted, and shall use its reasonable best efforts to preserve intact their present lines of business, maintain their rights and franchises and preserve their relationships with customers, suppliers and others having business dealings with them to the end that their ongoing businesses shall not be impaired in any material respect at the Effective Time; nrovided, however, that no action by America Online or its Subsidiaries with respect to matters specifically addressed by any other provision of this Section 5.1 shall be deemed a breach of this Section 5.1(a)(i) unless such action would constitute a breach of one or more of such other provisions. (ii) Other than in connection with acquisitions permitted by Section 5.1(e) or investments permitted by Section 5.2(g), America Online shall not, and shall not permit any of its Subsidiaries to, (A) enter into any new material line of business or (B) incur or commit to any capital expenditures or any obligations or liabilities in connection therewith other than capital expenditures and obligations or liabilities in connection therewith incurred or committed to in the ordinary course of business consistent with past practice. (b) Dividends; Chan�es in Share Capital. America Online shall not, and shall not permit any of its Subsidiaries to, and shall not propose to, (i) declaze or pay any � ��-so-oc;,�-czr y-ac_a�cHS-:��;, 35 dividends on or make other distributions in respect of any of its capital stock, except than as permitted by Section 5.1(b)(ii), (ii) split, combine or reclassi:y any of its capital stock or issue or authorize or propose the issuance of any other securities in respect of, in lieu of or in substitution for, shares of its capital stock, except for (x) any such transaction by a wholly owned Subsidiary of America Online which remains a wholly owned Subsidiary after consummation of such transaction or (y) a stock split of the America Online Common Stock or (iii) repurchase, redeem or otherwise acquire any shares of its capital stock or any securities convertible into or exercisable for any skares of its capital stock except for the purchase from time to time by America Online of America Online Common Stock (and the associated America Online Rights) in connection with the America Online Benefit Plans in the ordinary course of business consistent with past practice. (c) Issuance of Securities. America Online shall not, and shall not permit any of its Subsidiaries to, issue, deliver or sell, or authorize or propose the issuance, delivery or sale of, any shares of its capital stock of any class, any America Online Voting Debt or any securities convertible into or exercisable for, or any rights, warrants, calls or options to acquire, any such shares or America Online Voting Debt, or enter into any commitment, arrangement, undertaking or agreement with respect to any of the foregoing, other than (i) the issuance of America Online Common Stock (and the associated America Online Rights) upon the exercise of America Online Stock Options in accordance with their present terms or pursuant to America Online Stock Options or other stock based awards granted pursuant to clause (ii) below, (ii) the granting of America Online Stock Options or other stock based awards of or to acquire shares of America Online Common Stock granted under Benefit Plans outstanding on the date hereof in the ordinary course of business consistent with past practice, (iii) issuances by a wholly owned Subsidiary of America Online of capital stock to such Subsidiary's parent or another wholly owned Subsidiary of America Online, (iv) pursuant to acquisitions and investments as disclosed in Section 5.1(e) or 5.1(g) of the America Online Disclosure Schedule or the financings therefor or as disclosed in Section 5.1(c) of the America Online Disclosure Schedule, (v) issuances in accordance with the America Online Rights Agreement or (vi) issuances pursuant to the America Online Stock Option Agreement. (d) Governi� Documents. Except to the extent required to comply with their respective obligations hereunder or with applicable law, America Online and America Online Merger Sub shall not amend or propose to so amend their respective certificates of incorporation or bylaws. (e) No Ac�uisitions. Other than (i) pursuant to the Time Warner Stock Option Agreement, (ii) acquisitions disclosed in Section 5.1(e) of the America Online Disclosure Schedule and (iii) acquisitions in existing or related lines of business of America Online the fair market value of the total consideration (including the value of indebtedness acquired or assumed) for which does not exceed the amount specified in the aggregate for such acquisitions in Section 5.1(e)(iii) of the America Online Disclosure Schedule and none of which acquisitions referred to in this clause (iii) presents a material risk of making it materially more difficult to obtain any C0� ioC-CCO i-O�Zc9-A016'cCri9-MGA 36 approval or authorization required in connection with the Mergers under applicable Laws, America Online shall not, and shall not permit any of its Subsidiaries to, acquire or agree to acquire by merger or consolidation, or by purchasing a substantial equity interest in or a substantial portion of the assets of, or by any other manner, any business or any corporation, partnership, association or other business organization or division thereof or otherwise acquire or agree to acquire a.ny assets (excluding the acquisition of assets used in the operations of the business of America Online and its Subsidiaries in the ordinary course, which assets do not constitute a business unit, division or all or substantially all of the assets of the transferor); provided, however, that the foregoing shall not prohibit (x) internal reorganizations or consolidations involving existing Subsidiaries of America Online or (y) the creation of new Subsidiaries of America Online organized to conduct or continue activities otherwise permitted by this Agreement. ( fl No Dispositions. Other than (i) internal reorganizations or consolidations involving existing Subsidiaries of America Online, (ii) dispositions referred to in the America Online SEC Reports filed prior to the date of this Agreement or (iii) as may be required by or in conformance with law or regulation in order to permit or facilitate the consummation of the transactions contemplated hereby or as disclosed in Section 5.1( fl of the America Online Disclosure Schedule, America Online shall not, and shall not permit any of its Subsidiaries to, sell, lease or otherwise dispose of, or agree to sell, lease or otherwise dispose of, any of its assets (including capital stock of Subsidiaries of America Online but excluding inventory in the ordinary course of business), if the fair market value of the total consideration (including the value of the indebtedness acquired or assumed) therefor exceeds the amount specified in the aggregate for all such dispositions in Section 5.1(fl of the America Online Disclosure Schedule. (g) Investments: Indebtedness. America Online shall not, and shall not permit any of its Subsidiaries to, (i) other than in connection with acquisitions permitted by Section 5.1(e) or as disclosed in Section 5.1(g) of the America Online Disclosure Schedule, make any loans, advances or capital contributions to, or investments in, any other Person, other than (x) loans or investments by America Online or a Subsidiary of America Online to or in America Online or any Subsidiary of America Online, (y) employee loans or advances made in the ordinary course of business or (z) in the ordinary course of business consistent with past practice which are not, individually or in the aggregate, material to America Online and its Subsidiaries taken as a whole (provided that none of such transactions referred to in this clause (z) presents a material risk of making it more difficult to obtain any approval or authorization required in connection with the Mergers under Regulatory Law (as defined in Section 6.4(c)) or (ii) without regard to anything contained in the America Online Disclosure Schedule, incur any indebtedness for borrowed money or guarantee any such indebtedness of another Person, issue or sell any debt securities or warrants or other rights to acquire any debt securities of America Online or any of its Subsidiaries, guarantee any debt securities of another person, enter into any "keep well" or other agreement to maintain any financial statement condition of another Person (other than any «�holly owned Subsidiary) or enter into any arrangement having the economic effect of any of the l��l� C�'vC��-uL2E5-nJid:.�.^.?'MCA �" foregoing (collectively, "America Online Indebtedness"), except for (A) any America Online Indebtedness so long as (x) after the incurrence or issuance of such America Online Indebtedness America Online's consolidated indebtedness would not exceed 125% of the consolidated indebtedness of America Online as of the date hereof and (y) no America Online credit rating would be downgraded by either Moody's Investors Service, Inc. ("Moodv's") or Standard & Poor's Corporation ("S&P") (provided that the consummation of this Agreement or any of the transactions contemplated hereby shall not give rise to, cause or result in, a default or event of default under the agreement or instrument governing any such indebtedness or, an obligation to pay any amount thereunder solely as a result of the consummation of this Agreement or any of the transactions contemplated hereby) and (B) intercompany indebtedness between America Online and any of its wholly owned Subsidiaries or between such wholly owned Subsidiaries. (h) Tax-Free Qualification. America Online shall use its reasonable best efforts not to, and shall use its reasonable best efforts not to permit any of its Subsidiaries to, take any action (including any action otherwise permitted by this Section 5.1) that would prevent or impede the Mergers from qualifying as exchanges under Section 351 of the Code and as reorganizations under Section 368 of the Code; provided, however, that nothing hereunder shall limit the ability of America Online to exercise its rights and/or fulfill its obligations under the Stock Option Agreements. (i) Compensation. Except (x) as set forth in Sections 5.1(c) or 5.1(i) of the America Online Disclosure Schedule, (y) as required by law or by the terms of any collective bargaining agreement or other agreement currently in effect between America Online or any Subsidiary of America Online and any executive officer or employee thereof or (z) in the ordinary course of business consistent with past practice, America Online shall not increase the amount of compensation of any director, executive officer or key employee of America Online or any material Subsidiary or business unit of America Online, or make any increase in or commitment to increase any employee benefits, issue any additional America Online Stock Options, adopt or amend or make any commitment to adopt or amend any Benefit Plan or make any contribution, other than regularly scheduled contributions, to any America Online Benefit Plan. Any option committed to be granted or granted after the date hereof shall not accelerate as a result of the approval or consummation of any transaction contemplated by this Agreement. Should any modification of the America Online Option Plans necessary to effectuate the immediately preceding sentence render any transaction to which America Online is a party, and which is intended to be eligible for pooling-of-interest accounting under APB No. 16, ineligible for such treatment then such modification shall not be required; r vid , that the number of shares subject to options to be granted in the ordinary course consistent with past practice shall be reduced to reflect the effect of such acceleration. (j) AccountingMethods' Income Tax Elections. Except as disclosed in America Online SEC Reports filed prior to the date of this Agreement, or as required by a Governmental Entity, America Online shall not change its methods of accounting in effect at September 30, 1999, except as required by changes in GAAP as concurred in by America CO3%2C-0007-02269-.'+C'_6?C'r.5-2!Gn 38 Online's independent public accountants. America Online shall not (i) change its fiscal year (other than to the calendar year) or (ii) make any tax election that, individually or in the aggregate, would have a Material Adverse Effect on America Online. (k) Certain Agreements and Arran eg, ments. Except as disclosed in Section 5.1(k) of the America Online Disclosure Schedule, America Online shall not, and shall not permit any of its Subsidiaries to, enter into any America Online Internet Restrictions or any agreements or arrangements (x) that limit or otherwise restrict America Online or any of its Subsidiaries or any of their respective Affiliates or any successor thereto or that could, after the Effective Time, limit or restrict America Online or any of its Affiliates (including Holdco) or any successor thereto, from engaging or competing in any line of business or in any geographic azea which agreements or arrangements, individually or in the aggregate, would reasonably be expected to have a Material Adverse Effect on Holdco and its Subsidiaries, taken together, after giving effect to the Mergers or (y) of a type described in Section 5.1 (k) of the Time Warner Disclosure Schedule. (1) Satisfaction of Closing� Conditions. Except as required by law, America Online shall not, and shall not permit any of its Subsidiaries to, take any action that would, or would reasonably be expected to, result in (i) any of the conditions to the Mergers set forth in Article VII not being satisfied or (ii) a material delay in the satisfaction of such conditions. (m) No Related Actions. America Online will not, and will not permit any of its Subsidiaries to, agree or commit to do any of the foregoing. 5.2 Covenants of Time Warner. During the period from the date of this Agreement and continuing until the Effective Time, Time Warner agrees as to itself and its Subsidiaries that (except as expressly contemplated or permitted by this Agreement, the Stock Option Agreements or Section 5.2 (including its subsections) of the Time Wamer Disclosure Schedule or as required by a Governmental Entity or to the extent that America Online shall otherwise consent in writing, which consent shall not be unreasonably withheld or delayed): (a) Ordinarv Course. (i) Time Warner and its Subsidiaries shall carry on their respective businesses in the usual, regular and ordinary course in all material respects, in substantially the same manner as heretofore conducted, and shall use its reasonable best efforts to preserve intact their present lines of business, maintain their rights and franchises and preserve their relationships with customers, suppliers and others having business dealings with them to the end that their ongoing businesses shall not be impaired in any material respect at the Effective Time; roo vided, however, that no action by Time Warner or its Subsidiaries with respect to matters specifically addressed by any other provision of this Section 5.2 shall be deemed a breach of this Section 5.2(a)(i) unless such action would constitute a breach of one or more of such other provisions. 003�oC-�CC%-C2269-AOlEEC'r.5-N:GA 39 (ii) Other than in connection with acquisitions pzrmitted by Section 5.2(e) or investments permitted by Section 5.2(g), Time Warner shall not, and shall not permit any of its Subsidiaries to, (A) enter into any new material line of business or (B) incur or commit to any capital expenditures or any obligations or liabilities in connection therewith other than capital expenditures and obligations or liabilities in connection therewith as disclosed in Section 5.2(a) of the Time Warner Disclosure Schedule or incurred or committed to in the ordinary course of business consistent with past practice. (b) Dividends: Changes in Share Ca�ital. Time Warner shall not, and shall not permit any of its Subsidiaries to, and shall not propose to, (i) declare or pay any dividends on or make other distributions in respect of any of its capital stock, except (A) the declaration and payment of regular quarterly cash dividends not in excess of $0.045 per share of Time Warner Common Stock, $0.045 per share of Series LMCN-V Common Stock, $0.9375 per share of Time Warner Series E Preferred Stock, $0.1874 per share of Time Wazner Series F Preferred Stock, $0.9375 per share of Time Warner Series I Preferred Stock or $0.9375 per share of Series J Preferred Stock, in each case, with usual record and payment dates for such dividends in accordance with past dividend practice and, in the case of Time Warner Series Common Stock or Time Warner Preferred Stock, the certificate of designations therefor, and (B) for dividends by wholly owned Subsidiaries of Time Warner, distributions by TWE or TWE-A/N to the partners therein according to their respective governing documents in amounts and at times in the ordinary course of business consistent with past practice and as permitted by Section 5.2(b)(ii), (ii) split, combine or reclassify any of its capital stock or issue or authorize or propose the issuance of any other securities in respect of, in lieu of or in substitution for, shares of its capital stock, except for (x) any such transaction by a wholly owned Subsidiary of Time Warner which remains a wholly owned Subsidiary after consummation of such transaction or (y) a stock split of the Time Warner Common Stock, or (iii) except as set forth in Section 5.2(b) of the Time Warner Disclosure Schedule, repurchase, redeem or otherwise acquire any shares of its capital stock or any securities convertible into or exercisable for any shares of its capital stock except for the purchase from time to time by Time Warner of Time Warner Common Stock (and the associated Time Warner Rights) in connection with the Time Warner Benefit Plans in the ordinary course of business consistent with past practice. (c) Issuance of Securities. Time Warner shall not, and shall not permit any of its Subsidiaries to, issue, deliver or sell, or authorize or propose the issuance, delivery or sale of, any shares of its capital stock of any class, any Time Warner Voting Debt or any securities convertible into or exercisable for, or any rights, warrants, calls or options to acquire, any such shares or Time Warner Voting Debt, or enter into any commitment, arrangement, undertaking or agreement with respect to any of the foregoing, other than (i) the issuance of Time Warner Common Stock (and the associated Time Wamer Rights) upon the exercise of Time Warner Stock Options in accordance with their present terms or pursuant to Time Warner Stock Options or other stock based awazds granted pursuant to clause (ii) below, (ii) the grantir.g of Time Warner Stock Options or other stock based awards of or to acquire shares of Time Wamer Common Stock granted under Benefit Plans outstanding on the date hereof in the ordinary course co3;Fo-oo��-�zzE�-:,o_e=c::4-NC; 40 of�business consistent with past practice, (iii) issuances by a wholly owned Subsidiary of Time Warner of capital stock to such Subsidiary's parent or another wholly owned Subsidiary of Time Warner, (iv) pursuant to acquisitions and investrnents as disclosed in Section 5.2(e) or 5.2(g) of the Time Warner Disclosure Schedule or the financings therefor, (v) issuances disclosed in Section 5.2(c) of the Time Wamer Disclosure Schedule, (vi) issuances in accordance with the Time Warner Rights Agreement or (vii) issuances pursuant to the Time Warner Stock Option Agreement. (d) GoverninQ Documents. Except as set forth in Section 5.2(d) of the Time Warner Disclosure Schedule or to the extent required to comply with their respective obligations hereunder or with applicable law, Time Warner and Time Warner Merger Sub shall not amend or propose to so amend their respective certificates of incorporation or bylaws. (e) No Acquisitions. Other than (i) pursuant to the America Online Stock Option Agreement, (ii) acquisitions disclosed in Section 5.2(e) of the Time Wamer Disclosure Schedule and (iii) acquisitions in existing or related lines of business of Time Warner the fair market value of the total consideration (including the value of indebtedness acquired or assumed) for which does not exceed the amount specified in the aggregate for such acquisitions in Section 5.2(e)(iii) of the Time Warner Disclosure Schedule and none of which acquisitions referred to in this clause (iii) presents a material risk of making it materially more difficult to obtain any approval or authorization required in connection with the Mergers under applicable Laws, Time Warner shall not, and shall not permit any of its Subsidiaries to, acquire or agree to acquire by merger or consolidation, or by purchasing a substantial equity interest in or a substantial portion of the assets of, or by any other manner, any business or any corporation, partnership, association or other business organization or division thereof or otherwise acquire or agree to acquire any assets (excluding the acquisition of assets used in the operations of the business of Time Warner and its Subsidiaries in the ordinary course, which assets do not constitute a business unit, division or all or substantially of the assets of the transferor); rovi ed, however, that the foregoing shall not prohibit (x) intemal reorganizations or consolidations involving existing Subsidiaries of Time Warner or (y) the creation of new Subsidiaries of Time Warner organized to conduct or continue activities otherwise permitted by this Agreement. ( fl No Dis�ositions. Other than (i) internal reorganizations or consolidations involving existing Subsidiaries of Time Warner, (ii) dispositions referred to in the Time Warner SEC Reports filed prior to the date of this Agreement, (iii) as may be required by or in conformance with law or regulation in order to permit or facilitate the consummation of the transactions contemplated hereby or (iv) as disclosed in Section 5.2( fl of the Time Wamer Disclosure Schedule, Time Warner shall not, and shall not permit any of its Subsidiaries to, sell, lease or otherwise dispose of, or agree to sell, lease or otherwise dispose of, any of its assets (including capital stock of Subsidiaries of Time Warner but excluding inventory in the ordinary course of business), if the fair market value of the total consideration (including the value of the indebtedness acquired or assumed) therefor exceeds the amount specified in the aggregate for all such dispositions in Section 5.2(� of the Time Warner Disclosure Schedule. .,�37c�—.��--��2o9—nOiP�CE9—'•:GA 41 (g) Investments: Indebtedness. Time Warner shall not, and shall not permit any of its Subsidiaries to, (i) other than in connection with acquisitions permitted by Section 5.2(e) or as disclosed in Section 5.1(g) of the Time Warner Disclosure Schedule, make any loans, advances or capital contributions to, or investments in, any other Person, other than (x) loans or investments by Time Warner or a Subsidiary of Time Warner to or in Time Warner or any Subsidiary of Time Warner, (y) employee loans or advances made in the ordinary course of business or (z) in the ordinary course of business consistent with past practice which are not, individually or in the aggregate, material to Time Warner and its Subsidiaries taken as a whole (provided that none of such transactions refened to in this clause (z) presents a material risk of making it more difficult to obtain any approval or authorization required in connection with the Mergers under Regulatory Law or (ii) without regard to anything contained in the Time Warner Disclosure Schedule, incur any indebtedness for borrowed money or guarantee any such indebtedness of another Person, issue or sell any debt securities or wanants or other rights to acquire any debt securities of Time Warner or any of its Subsidiaries, guarantee any debt securities of another person, enter into any "keep well" or other agreement to maintain any financial statement condition of another Person (other than any wholly owned Subsidiary) or enter into any arrangement having the economic effect of any of the foregoing (collectively, "Time Warner Indebtedness"), except for (A) any Time Warner Indebtedness so long as (x) after the incurrence or issuance of such Time Warner Indebtedness Time Warner's consolidated indebtedness would not exceed 125% of the consolidated indebtedness of Time Warner as of the date hereof and (y) no Time Warner credit rating would be downgraded by either Moody's or S&P (provided that the consummation of this Agreement or any of the transactions contemplated hereby shall not give rise to, cause or result in, a default or event of default under the agreement or instrument governing any such indebtedness or, an obligation to pay any amount thereunder solely as a result of the consummation of this Agreement or any of the transactions contemplated hereby) and (B) intercompany indebtedness between Time Warner and any of its wholly owned Subsidiaries or between such wholly owned Subsidiaries. (h) Tax-Free Qualification. Time Warner shall use its reasonable best efforts not to, and shall use its reasonable best efforts not to permit any of its Subsidiaries to, take any action (including any action otherwise permitted by this Section 5.2) that would prevent or impede the Mergers from qualifying as exchanges under Section 351 of the Code and as reorganizations under Section 368 of the Code; provided, however, that nothing hereunder shall limit the ability of Time Warner to exercise its rights and/or fulfill its obligations under the Stock Option Agreements. (i) Com�ensation. Except (x) as set forth in Section 5.2(c) or 5.2 (i) of the Time Warner Disclosure Schedule, (y) as required by law or by the terms of any collective bargaining agreement or other agreement currently in effect between Time Warner or any Subsidiary of Time Warner and any executive officer or employee thereof or (z) in the ordinary course of business consistent with past practice, Time Warner shall not increase the amount of compensation of any director, executive officer or key employee of Time Wamer or any material Subsidiary or business unit of Time Warner, or make any increase in or commitment to increase OC376^v-000�-02269-nJ:EEC:^:9-N.GA 42 I � any employee benefits, issue any additional Time Warner Stock Options, adopt or amend or make any commitment to adopt or amend any Benefit Plan or make any contribution, other than regularly scheduled contributions, to any Time Wamer Benefit Plan. Any option granted or committed to be granted after the date hereof shall not accelerate as a result of the approval or consummation of any transaction contemplated by this Agreement. Should any modification of the Time Warner Option Plans necessary to effectuate the immediately preceding sentence render any transaction to which Time Warner is a party, and which is intended to be eligible for pooling-of-interest accounting under APB No. 16, ineligible for such treatment then such modification shall not be required; .provided that the number of shares subject to options to be granted in the ordinary course consistent with past practice shall be reduced to reflect the effect of such acceleration. (j) Accounting Methods: Income Tax Elections. Except as disclosed in Time Warner SEC Reports filed prior to the date of this Agreement, or as required by a Governmental Entity, Time Warner shall not change its methods of accounting in effect at September 30, 1999, except as required by changes in GAAP as concurred in by Time Warner's independent public accountants. Time Warner shall not (i) change its fiscal year or (ii) make any tax election that, individually or in the aggregate, would have a Material Adverse Effect on Time Warner. (k) Certain Agreements and Arrangements. Time Wamer shall not, and shall not permit any of its Subsidiaries to, enter into any Time Warner Intemet Restrictions or any agreements or arrangements (x) that limit or otherwise restrict Time Warner or any of its Subsidiaries or any of their respective Affiliates or any successor thereto, or that could, after the Effective Time, limit or restrict America Online or any of its Affiliates (including Holdco) or any successor thereto, from engaging or competing in any line of business or in any geographic area which agreements or arrangements, individually or in the aggregate, would reasonably be expected to have a Material Adverse Effect on Holdco and its Subsidiaries, taken together, after giving effect to the Mergers or (y) of a type described in Section 5.2(k) of the America Online Disclosure Schedule. (1) Satisfaction of Closing Conditions. Except as required by law, Time Warner shall not, and shall not permit any of its Subsidiaries to, take any action that would, or would reasonably be expected to, result in (i) any of the conditions to the Mergers set forth in Article VII not being satisfied or (ii) a material delay in the satisfaction of such conditions. (m) No Related Actions. Time Warner will not, and will not permit any of its Subsidiaries to, agree or commit to do any of the foregoing. 5.3 Governmental Filines. Each party shall (a) confer on a reasonable basis with the other and (b) report to the other (to the extent permitted by law or regulation or any applicable confidentiality agreement) on operational matters. Time Warner and America Online shall file all reports required to be filed by each of them with the SEC (and all other OC3�6C-C�C7-Q2269-AG18�C49-M.G;y 43 Govemmental Entities) between the date of this Agreement and the Effective Time and shall, if requested by the other party and to the extent permitted by law or regulation or any applicable confidentiality agreement, deliver to the other party copies of all such reports, announcements and publications promptly after such request. 5.4 Control of Other Partv's Business. Nothing contained in this Agreement shall give Time Warner, directly or indirectly, the right to control or direct America Online's operations and nothing contained in this Agreement shall give America Online, directly or indirectly, the right to control or direct Time Warner's operations prior to the Effective Time. Prior to the Effective Time, each of Time Warner and America Online shall exercise, consistent with the terms and conditions of this Agreement, complete control and supervision over its respectiye operations. ARTICLE VI ADDITIONAL AGREEMENTS 6.1 Pre�aration of Proxv Statement: Stockholders Meetings. (a) As promptly as reasonably practicable following the date hereof, America Online and Time Warner shall cooperate in preparing and each shall cause to be filed with the SEC mutually acceptable proxy materials which shall constitute the joint proxy statemendprospectus relating to the matters to be submitted to the America Online stockholders at the America Online Stockholders Meeting and the matters to be submitted to the Time Warner stockholders at the Time Warner Stockholders Meeting (such proxy statement/prospectus, and any amendments or supplements thereto, the "Joint Proxv Statement/Prospectus") and Holdco shall prepare and file with the SEC a registration statement on Form S-4 with respect to the issuance of Holdco Capital Stock in the Mergers (such Form S-4, and any amendments or supplements thereto, the "Form S-4"). The Joint Proxy Statement/Prospectus will be included as a prospectus in and will constitute a part of the Form S-4 as Holdco's prospectus. Each of America Online and Time Warner shall use reasonable best efforts to have the Joint Proxy StatementlProspectus cleared by the SEC and the Form S-4 declared effective by the SEC and to keep the Form S-4 effective as long as is necessary to consummate the Mergers and the transactions contemplated thereby. America Online and Time Warner shall, as promptly as practicable after receipt thereof, provide the other party copies of any written comments and advise the other party of any oral comments, with respect to the Joint Proxy. StatementlProspectus or Form S-4 received from the SEC. The parties shall cooperate and provide the other with a reasonable opportunity to review and comment on any amendment or supplement to the Joint Proxy Statement/Prospectus and the Form S-4 prior to filing such with the SEC, and will provide each other with a copy of all such filings made with th� SEC. Notwithstanding any other provision herein to the contrary, no amendment or supplement (including by incorporation by reference) to the Joint Proxy Statement/Prospectus or the Form S- v0378�-COC7-�22o9-AO_?EC-9-h;�F 44 4 shall be made without the approval of both parties, which approval shall not be unreasonably withheld or delayed; rovided that with respect to documents filed by a party which are incorporated by reference in the Form S-4 or Joint Proxy Statement/Prospectus, this right of approval shall apply only with respect to information relating to the other party or its business, fmancial condition or results of operations; and provided further that America Online, in connection with a Change in the America Online Recommendation (as defined in Section 6.1(c)), and Time Warner, in connection with a Change in the Time Warner Recommendation (as defined in Section 6.1(b)), may amend or supplement the Joint Proxy Statement/Prospectus or Form S-4 (including by incorporation by reference) pursuant to a Qualifying Amendment (as defined below) to effect such a Change, and in such event, this right of approval shall apply only with respect to information relating to the other party or its business, financial condition or results of operations, and shall be subject to the right of each party to have its Board of Directors' deliberations and conclusions to be accurately described. A"Qualifying Amendment" means an amendment or supplement to the Joint Proxy Statement/Prospectus or Form S-4 (including by incorporation by reference) to the extent it contains (i) a Change in the America Online Recommendation or a Change in the Time Warner Recommendation (as the case may be), (ii) a statement of the reasons of the Board of Directors of America Online or Time Warner (as the case may be) for making such Change in the America Online Recommendation or Change in the Time Warner Recommendation (as the case may be) and (iii) additional information reasonably related to the foregoing. America Online will use reasonable best efforts to cause the Joint Proxy Statements/Prospectus to be mailed to America Online stockholders, and Time Warner will use reasonable best efforts to cause the Joint Proxy StatementlProspectus to be mailed to Time Warner's stockholders, in each case as promptly as practicable after the Form S-4 is declared effective under the Securities Act. Holdco shall also take any action (other than qualifying to do business in any jurisdiction in which it is not now so qualified or to file a general consent to service of process) required to be taken under any applicable state securities laws in connection with the Mergers and each of Time Wamer and America Online shall furnish all information concerning it and the holders of its capital stock as may be reasonably requested in connection with any such action. Each party will advise the other party, promptly after it receives notice ihereof, of the time when the Form S-4 has become effective, the issuance of any stop order, the suspension of the qualification of the Holdco Capital Stock issuable in connection with the Mergers for offering or sale in any jurisdiction, or any request by the SEC for amendment of the Joint Proxy Statement/Prospectus or the Form S-4. If at any time prior to the Effective Time any information relating to America Online or Time Warner, or any of their respective affiliates, officers or directors, should be discovered by America Online or Time Warner which should be set forth in an amendment or supplement to any of the Form S-4 or the Joint Proxy Statement/Prospectus so that any of such documents would not include any misstatement of a material fact or omit to state any material fact necessary to make the statements therein, in light of the circumstances under which they were made, not misleading, the party which discovers such information shall promptly notify the other party hereto and, to the extent required by law, rules or regulations, an appropriate amendment or supplement describing such information shall be promptly filed with the SEC and disseminated to the stockholders of America Online and Time Warner. 003'r?�-G00'.-02269-i10!2EC5c_,y�p 45 (b) Time Warner shall duly take all lawful action to call, give notice of, convene and hold a meeting of its stockholders on a date determined in accordance with the mutual agreement of Time Warner and America Online (the "Time Warner Stockholders Meetin ") for the purpose of obtaining the Required Time Warner Vote with respect to the transactions contemplated by this Agreement and shall take all lawful action to solicit the adoption of this Agreement by the Required Time Warner Vote; and the Board of Directors of Time Warner shall recommend adoption of this Agreement by the stockholders of Time Warner to the effect as set forth in Section 4.2( fl(the "Time Warner Recommendation"), and shall not, unless America Online makes a Change in the America Online Recommendation, (x) withdraw, modify or qualify (or propose to withdraw, modify or qualify) in any manner adverse to America Online such recommendation or (y) take any action or make any statement (other than any action described in the foregoing clause (x)) in connection with the Time Warner Stockholders Meeting inconsistent with such recommendation (collectively, a"Change in the Time Warner Recommendation"); provided, however, any action or statement under clause (y) will not be deemed a Change in the Time Warner Recommendation provided (I) such action or statement is taken or made pursuant to advice from Cravath, Swaine & Moore, counsel to Time Warner, to the effect that such action or statement is required by applicable Law, (II) if a Time Warner Public Proposal has been made and not rescinded, such action or statement shall not relate to such Time Warner Public Proposal other than any factual statement required by any regulatory authority (including the SEC) and shall in any event include a rejection of such Time Warner Public Proposal and (III) such action or statement also includes a reaffirmation of the Time Warner Board of Directors' approval of the Mergers and the other transactions contemplated hereby and recommendation to the Time Warner stockholders to adopt this Agreement; .Qrovided further, however, that the Board of Directors of Time Wamer may make a Change in the Time Warner Recommendation pursuant to Section 6.5 hereof. Notwithstanding any Change in the Time Wamer Recommendation, this Agreement shall be submitted to the stockholders of Time Warner at the Time Warner Stockholders Meeting for the purpose of adopting this Agreement and nothing contained herein shall be deemed to relieve Time Warner of such obligation. (c) America Online shall duly take all lawful action to call, give notice of, convene and hold a meeting of its stockholders on a date determined in accordance with the mutual agreement of America Online and Time Warner (the "America Online Stockholders Meetin ") for the purpose of obtaining the America Online Stockholder Approval with respect to the transactions contemplated by this Agreement and shall take all lawful action to solicit the adoption of this Agreement, and the Board of Directors of America Online shall recommend adoption of this Agreement by the stockholders of America Online to the effect as set forth in Section 4.1(fl (the "America Online Recommendation"), and shall not, unless Time Warner makes a Change in the Time Warner Recommendation, (x) withdraw, modify or qualify (or propose to withdraw, modify or qualify) in any manner adverse to Time Warner such recommendation or (y) take any action or make any statement (other than any action described in the foregoing clause (x)) in connection with the America Online Stockholders Meeting inconsistent with such recommendation (collectively, a"Change in the America Online Recommendation"); provided, however, any action or statement under clause (y) will not be CC372C-OCC7-02269-AC:BECH9-MGi, 46 deemed a Change in the America Online Recommendation provided (I) such action or statement is taken or made pursuant to advice from Simpson Thacher & Bartlett, counsel to America Online, to the effect that such action or statement is required by applicable Law, (II) if an America Online Public Proposal has been made and not rescinded, such action or statement shall not relate to such America Online Public Proposal other than any factual statement required by any regulatory authority (including the SEC) and shall in any event include a rejection of such America Online Public Proposal and (III) such action or statement also includes a reaffirmation of the America Online Board of Directors' approval of the Mergers and the other transactions contemplated hereby and recommendation to the America Online stockholders to adopt this Agreement; provided further, however, that the Board of Directors of America Online may make a Change in the America Online Recommendation pursuant to Section 6.5 hereof. Notwithstanding any Change in the America Online Recommendation, this Agreement shall be submitted to the stockholders of America Online at the America Online Stockholders Meeting for the purpose of adopting this Agreement and nothing contained herein shall be deemed to relieve America Online of such obligation. 6.2 Holdco Board of Directors: Executive Officers. (a) At or prior to the Effective Time, each party hereto will take all action necessary to (i) cause the Board of Directors of Holdco and each committee thereof as of the Effective Time to be comprised in accordance with Schedule 6.2(a) hereto and (ii) cause the individuals listed in Schedule 6.2(a) hereto to be appointed as officers of Holdco as of the Effective Time in accordance with Schedule 6.2(a) hereto. (b) Promptly following the date hereof, each party hereto will take all action necessary to form the Transition Team, in accordance with Schedule 6.2(a) hereto. Following the Effective Time, each party hereto will comply, and will cause Holdco to comply, with the provisions of Schedule 6.2(a) hereto which by their terms are applicable from and after the Effective Time. 6.3 Access to Information. Upon reasonable notice, each party shall (and shall cause its Subsidiaries to) afford to the officers, employees, accountants, counsel, financial advisors and other representatives of the other party reasonable access during normal business hours, during the period prior to the Effective Time, to all its properties, books, contracts, commitments, records, officers and employees and, during such period, such party shall (and shall cause its Subsidiaries to) furnish promptly to the other party (a) a copy of each report, schedule, registration statement and other document filed, published, announced or received by it during such period pursuant to the requirements of Federal or state securities laws, the Communications Act, the HSR Act and the laws, rules and regulations of Franchising Authorities and PUCs, as applicable (other than documents which such party is not permitted to disclose under applicable law), and (b) all other information concerning it and its business, properties and personnel as such other party may reasonably request; �rovided, however, that either party may restrict the foregoing access to the extent that (i) any law, treaty, rule or regulation of any 003�00-000'-C2269-A018�Ca9-M.GA 47 Governmental Entity applicable to such party or any contract requir�s such party or its Subsidiaries to restrict or prohibit access to any such properties or information or (ii) the information is subject to confidentiality obligations to a third party. The parties will hold any such information obtained pursuant to this Section 6.3 in confidence in accordance with, and shall otherwise be subject to, the provisions of the confidentiality letter dated December 10, 1999, between Time Warner and America Online (the "Confidentiality Agreement"), which Confidentiality Agreement shall continue in full force and effect. Any investigation by either of America Online or Time Warner shall not affect the representations and warranties of the other. 6.4 Reasonable Best Efforts. (a) Subject to the terms and conditions of this Agreement, each party will use its reasonable best efforts to take, or cause to be taken, all actions and to do, or cause to be done, all things necessary, proper or advisable under this Agreement and applicable laws and regulations to consummate the Mergers and the other transactions contemplated by this Agreement as soon as practicable after the date hereof, including (i) preparing and filing as promptly as practicable all documentation to effect all necessary applications, notices, petitions, filings, tax ruling requests and other documents and to obtain as promptly as practicable all Necessary Consents and all other consents, waivers, licenses, orders, registrations, approvals, permits, rulings, authorizations and clearances necessary or advisable to be obtained from any third party and/or any Govemmental Entity in order to consummate the Mergers or any of the other transactions contemplated by this Agreement and the Stockholders Agreements (collectively, the "Re�uired A�provals") and (ii) taking all reasonable steps as may be necessary to obtain all such Necessary Consents and the Required Approvals. In furtherance and not in limitation of the foregoing, each party hereto agrees to make, as promptly as practicable, to the extent it has not already done so, (i) an appropriate filing of a Notification and Report Form pursuant to the HSR Act with respect to the transactions contemplated hereby (which filing shall be made in any event within 10 Business Days of the date hereo fl, (ii) appropriate filings with the FCC, Franchising Authorities and PUCs with respect to the transactions contemplated hereby, (iii) appropriate filings with the European Commission in accordance with applicable competition, merger control, antitrust, investment or similar laws and any necessary filings under the Canadian Investment Regulations within the time periods specified thereunder, and (iv) all other necessary filings with other Governmental Entities relating to the Mergers, and, in each case, to supply as promptly as practicable any additional information and documentary material that may be requested pursuant to such laws or by such authorities and to use reasonable best efforts to cause the expiration or termination of the applicable waiting periods under the HSR Act and the receipt of Required Approvals under such other laws or from such authorities as soon as practicable. Notwithstanding the foregoing, nothing in this Section 6.4 shall require, or be deemed to require, (i) America Online or Time Warner to agree to or effect any divestiture, hold separate any business or assets or take any other action if doing so would, individually or in the aggregate, reasonably be expected to result in a Material Adverse Effect on Holdco after the Mergers or (ii) America Online or Time Warner to agree to or effect any divestiture, hold separate any business or take any other action that is not conditional on the consummation of the CO��cO-�00i-�226�-�C? EEC'r.9-9:GA 48 Mergers. Neither party shall take or agree to take any action identified in clause (i) or (ii) of the immediately preceding sentence without the prior written consent of the other party (which shall not be unreasonably withheld or delayed). (b) Each of Time Warner and America Online shall, in connection with the efforts referenced in Section 6.4(a) to obtain all Required Approvals, use its reasonable best efforts to (i) cooperate in all respects with each other in connection with any filing or submission and in connection with any investigation or other inquiry, including any proceeding initiated by a private party, (ii) promptly inform the other party of any communication received by such party from, or given by such party to, the FCC, Franchising Authorities, PUCs, the Antitrust Division of the Department of Justice (the "DOJ"), the Federal Trade Commission (the "FT ") or any other Governmental Entity and of any material communication received or given in connection with any proceeding by a private party, in each case regrading any of the transactions contemplated hereby, and (iii) consult with each other in advance to the extent practicable of any meeting or conference with, the FCC, Franchising Authorities, PUCs, the DOJ, the FTC or any such other Governmental Entity or, in connection with any proceeding by a private party, with any other Person, and to the extent permitted by the FCC, PUCs, the DOJ, the FTC or such other applicable Governmental Entity or other Person, give the other party the opportunity to attend and participate in such meetings and conferences. (c) In furtherance and not in limitation of the covenants of the parties contained in Section 6.4(a) and 6.4(b), if any administrative or judicial action or proceeding, including any proceeding by a private party, is instituted (or threatened to be instituted) challenging any transaction contemplated by this Agreement as violative of any Regulatory Law (as defined below), or if any statute, rule, regulation, executive order, decree, injunction or administrative order is enacted, entered, promulgated or enforced by a Governmental Entity which would make the Mergers or the other transactions contemplated hereby illegal or would otherwise prohibit or materially impair or delay the consummation of the Mergers or the other transactions contemplated hereby, each of Time Warner and America Online shall cooperate in all respects with each other and use its respective reasonable best efforts, including without limitation, subject to the penultimate sentence of Section 6.4(a), selling, holding separate or otherwise disposing of or conducting their business in a specified manner, or agreeing to sell, hold separate or othervvise dispose of or conduct their business in a specified manner or permitting the sale, holding separate or other disposition of, any assets of America Online, Time Warner or their respective Subsidiaries or the conducting of their business in a specified manner, to contest and resist any such action or proceeding and to have vacated, lifted, reversed or overturned any decree, judgment, injunction or other order, whether temporary, preliminary or permanent, that is in effect and that prohibits, prevents or restricts consummation of the Mergers or the other transactions contemplated by this Agreement and to have such statute, rule, regulation, executive order, decree, injunction or administrative order repealed, rescinded or made inapplicable so as to permit consummation of the transactions contemplated by this Agreement. Notwithstanding the foregoing or any other provision of this Agreement, nothing in this Section 6.4 shall limit a party's right to terminate this Agreement pursuant to Section 8.1(b) 003720-0007-C2269-AOlEEC:-:9-v�A 49 or 8.1(c) so long as such party has up to then complied with its obligations under this Section 6.4. For purposes of this Agreement, "Regulatory.Law" means the Sherman Act, as amended, the EC Merger Regulation, the Clayton Act, as amended, the HSR Act, the Federal Trade Commission Act, as amended, the Communications Act, the Canadian Investment Regulations, and all other federal, state and foreign, if any, sta±utes, rules, regulations, orders, decrees, administrative and judicial doctrines and other laws that are designed or intended to prohibit, restrict or regulate (i) mergers, acquisitions or other business combinations, (ii) foreign investment or (iii) actions having the purpose or effect of monopolization or restraint of trade or lessening of competition. (d) America Online and its Board of Directors shall, if any state takeover statute or similaz statute becomes applicable to this Agreement, the Mergers, the Stock Option Agreements or any other transactions contemplated hereby or thereby, take all action reasonably necessary to ensure that the Mergers and the other transactions contemplated by this Agreement and the Stock Option Agreements may be consummated as promptly as practicable on the terms contemplated hereby or thereby and otherwise to minimize the effect of such statute or regulation on this Agreement, the Mergers, the Stock Option Agreements and the other transactions contemplated hereby or thereby. (e) Time Warner and its Board of Directors shall, if any state takeover statute or similar statute becomes applicable to this Agreement, the Mergers, the Stock Option Agreements or any other transactions contemplated hereby or thereby, take all action reasonably necessary to ensure that the Mergers and the other transactions contemplated by this Agreement and the Stock Option Agreements may be consummated as promptly as practicable on the terms contemplated hereby or thereby and otherwise to minimize the effect of such statute or regulation on this Agreement, the Mergers, the Stock Option Agreements and the other transactions contemplated hereby or thereby. 6.5 Acquisition Proposals. (a) Without limitation on any of such party's other obligations under this Agreement (including under Article V hereo fl, each of America Online and Time Warner agrees that neither it nor any of its Subsidiaries nor any of the officers and d'uectors of it or its Subsidiaries shall, and that it shall use its reasonable best efforts to cause its and its Subsidiaries' employees, agents and representatives (including any investment banker, attorney or accountant retained by it or any of its Subsidiaries) not to, directly or indirectly, (i) initiate, solicit, encourage or knowingly facilitate any inquiries or the making of any proposal or offer with respect to, or a transaction to effect, a merger, reorganization, share exchange, consolidation, business combination, recapitalization, liquidation, dissolution or similar transaction involving it or any of its Significant Subsidiaries (as defined in Rule 1-02 of Regulation S-X of the SEC and, with respect to Time Warner, including TWE), or any purchase or sale of 20% or more of the consolidated assets (including without limitation stock of its Subsidiaries) of such party and its Subsidiaries; taken as a whole, or any purchase or sale of, or tender or exchange offer for, the OC3'�0-OOC7-C2269-A0:6°_CF.9-MGA 50 equity securities of such party that, if consummated, would result in any Person (or the stockholders of such Person) beneficially owning securities representing 20% or more of the total voting power of such party (or of the surviving parent entity in such transaction) or any of its Significant Subsidiaries (any such proposal, offer or transaction (other than a proposal or offer made by the other party or an Affiliate thereo fl being hereinafter referred to as an"Acquisition Proposal"), (ii) have any discussion with or provide any confidential information or data to any Person relating to an Acquisition Proposal, or engage in any negotiations concerning an Acquisition Proposal, or knowingly facilitate any effort or attempt to make or implement an Acquisition Proposal, (iii) approve or recommend, or propose publicly to approve or recommend, any Acquisition Proposal or (iv) approve or recommend, or propose to approve or recommend, or execute or enter into, any letter of intent, agreement in principle, merger agreement, acquisition agreement, option agreement or other similar agreement or propose publicly or agree to do any of the foregoing related to any Acquisition Proposal. (b) Notwithstanding anything in this Agreement to the contrary, each of America Online and Time Warner or its respective Board of Directors shall be permitted to (A) to the extent applicable, comply with Rule 14d-9 and Rule 14e-2 promulgated under the Exchange Act with regazd to an Acquisition Proposal, (B) effect a Change in the America Online or Time Warner Recommendation, as the case may be, or (C) engage in any discussions or negotiations with, or provide any information to, any Person in response to an unsolicited bona fide written Acquisition Proposal by any such Person, if and only to the extent that, in any such case referred to in clause (B) or (C), (i) its Stockholders Meeting shall not have occurred, (ii) (x) in the case of clause (B) above, it has received an unsolicited bona fide written Acquisition Proposal from a third party and its Board of Directors concludes in good faith that such Acquisition Proposal constitutes a Superior Proposal (as defined below) and (y) in the case of clause (C) above, its Board of Directors concludes in good faith that there is a reasonable likelihood that such Acquisition Proposal could constitute a Superior Proposal, (iii) in the case of clause (B) or (C) above, its Board of Directors, after consultation with outside counsel, determines in good faith that the failure to take such action would be inconsistent with its fiduciary duties under applicable Law, (iv) prior to providing any information or data to any Person in connection with an Acquisition Proposal by any such Person, its Board of Directors receives from such Person an executed confidentiality agreement having provisions that are customary in such agreements, as advised by counsel, .provided that if such confidentiality agreement contains provisions that are less restrictive than the comparable provision, or omits restrictive provisions, contained in the Confidentiality Agreement, then the Confidentiality Agreement will be deemed to be amended to contain only such less restrictive provisions or to omit such restrictive provisions, as the case may be, and (v) prior to providing any information or data to any Person or entering into discussions or negotiations with any Person, such party notifies the other party promptly of such inquiries, proposals or offers received by, any such information requested from, or any such discussions or negotiations sought to be initiated or continued with, any of its representatives indicating, in connection with such notice, the name of such Person and the material terms and conditions of any inquiries, proposals or offers. Each of America Online and Time Warner agrees that it will promptly keep the other party informed of �p37�C-OOC7-v2269-AOlEEC'r.9-v�� 51 the status and terms of any such proposals or offers and the status and terms of any such discussions or negotiations. Each of America Online and Time Warner agrees that it will, and will cause its officers, directors and representatives to, immediately cease and cause to be terminated any activities, discussions or negotiations existing as of the date of this Agreement with any parties conducted heretofore with respect to any Acquisition Proposal. Each of America Online and Time Warner agrees that it will use reasonable best efforts to promptly inform its directors, officers, key employees, agents and representatives of the obligations undertaken in this Section 6.5. Nothing in this Section 6.5 shall (x) permit America Online or Time Warner to terminate this Agreement (except as specifically provided in Article VIII hereo fl or (y) affect any other obligation of America Online or Time Warner under this Agreement. Neither America Online nor Time Warner shall submit to the vote of its stockholders any Acquisition Proposal other than the America Online Merger or Time Warner Merger, respectively. "Superior Proposal" means with respect to America Online or Time Wamer, as the case may be, a bona fide written proposal made by a Person other than either such party which is (I) for a merger, reorganization, consolidation, share exchange, business combination, recapitalization, or similar transaction involving such party as a result of which the other party thereto or its stockholders will own 40% or more of the combined voting power of the entity surviving or resulting from such transaction (or the ultimate parent entity thereo fl, and (II) is on terms which the Board of Directors of such party in good faith concludes (following receipt of the advice of its financial advisors and outside counsel), taking into account, among other things, all legal, financial, regulatory and other aspects of the proposal and the Person making the proposal, (x) would, if consummated, result in a transaction that is more favorable to its stockholders (in their capacities as stockholders), from a financial point of view, than the transactions contemplated by this Agreement and (y) is reasonably capable of being completed. 6.6 Fees and Expenses. Subject to Section 8.2, whether or not the Mergers are consummated, all Expenses (as defined below) incurred in connection with this Agreement and the transactions contemplated hereby shall be paid by the party incurring such Expenses, except (a) if the Mergers are consummated, the surviving corporation of each Merger shall pay, or cause to be paid, any and all property or transfer taxes imposed in connection with such Merger and (b) Expenses incurred in connection with the filing, printing and mailing of the Joint Proxy Statement/Prospectus and Form S-4, which shall be shared equally by America Online and Time Warner. As used in this Agreement, "Ex�enses" includes all out-of-pocket expenses � (including, without limitation, all fees and expenses of counsel, accountants, investment bankers, experts and consultants to a party hereto and its affiliates) incurred by a party or on its behalf in connection with or related to the authorization, preparation, negotiation, execution and performance of this Agreement, the Stock Option Agreements and the Voting Agreement and the transactions contemplated hereby and thereby, including the preparation, printing, filing and mailing of the Joint Proxy Statement/Prospectus and Form S-4 and the solicitation of stockholder approvals and all other matters related to the transactions contemplated hereby and thereby. The parties hereto shall cooperate with each other in preparing, executing and filing any Tax Returns with respect to property or transfer taxes. �0378.-�0�i-C2269-?.Oi8�Cri9-MG�. 52 6.7 Directors' and Officers' Indemnification and Insurance. (a) Holdco shall (i) indemnify and hold harmless, and provide advancement of expenses to, all past and present directors, officers and employees of Time Warner and its Subsidiaries (in all of their capacities) (a) to the same extent such persons are indemnified or have the right to advancement of expenses as of the date of this Agreement by Time Warner pursuant to Time Wamer's certificate of incorporation, bylaws and indemnification agreements, if any, in existence on the date hereof with any directors, officers and employees of Time Warner and its Subsidiaries and (b) without limitation to clause (a), to the fullest extent permitted by law, in each case for acts or omissions occurring at or prior to the Effective Time (including for acts or omissions occurring in connection with the approval of this Agreement and the consummation of the transactions contemplated hereby), (ii) include and cause to be maintained in effect in Holdco's (or any successor's) certificate of incorporation and bylaws after the Effective Time, provisions regarding elimination of liability of directors, indemnification of officers, directors and employees and advancement of expenses which are, in the aggregate, no less advantageous to the intended beneficiaries than the corresponding provisions contained in the current certificate of incorporation and bylaws of Time Warner and (iii) cause to be maintained for a period of six years after the Effective Time the current policies of directors' and officers' liability insurance and fiduciary liability insurance maintained by Time Warner rovided that Holdco (or any successor) may substitute therefor one or more policies of at least the same coverage and amounts containing terms and conditions which aze, in the aggregate, no less advantageous to the insured) with respect to claims arising from facts or events that occurred on or before the Effective Time; provided, however, that in no event shall Holdco be required to expend in any one year an amount in excess of 200% of the annual premiums currently paid by Time Warner for such insurance; and, provided further that if the annual premiums of such insurance coverage exceed such amount, Holdco shall be obligated to obtain a policy with the greatest coverage available for a cost not exceeding such amount. The obligations of Holdco under this Section 6.7(a) shall not be terminated or modified ixi such a manner as to adversely affect any indemnitee to whom this Section 6.7(a) applies without the consent of such affected indemnitee (it being expressly agreed that the indemnitees to whom this Section 6.7(a) applies shall be third party beneficiaries of this Section 6.7(a)). (b) Holdco shall (i) indemnify and hold harmless, and provide advancement of expenses to, all past and present directors, officers and employees of America Online and its Subsidiaries (in all of their capacities) (a) to the same extent such persons are indemnified or have the right to advancement of expenses as of the date of this Agreement by America Online pursuant to America Online's certificate of incorporation, bylaws and indemnification agreements, if any, in existence on the date hereof with any directors, officers and employees of America Online and its Subsidiaries and (b) without limitation to clause (a), to the fullest extent permitted by law, in each case for acts or omissions occurring at or prior to the Effective Time (including for acts or omissions occurring in connection with the approval of this Agreement and the consummation of the transactions contemplated hereby), (ii) include and cause to be maintained in effect in Holdco's (or any successor's) certificate of incorporation and bylaws after the Effective Time, provisions regarding elimination of liability of directors, indemnification of C037"cv-G007-02269-AC16cCFi9-�:G:, 53 officers, directors and employees and advancement of expenses which are, in the aggregate, no less advantageous to the intended beneficiaries than the corresponding provisions contained in the current certificate of incorporation and bylaws of America Online and (iii) cause to be maintained for a period of six years after the Effective Time the current policies of directors' and officers' liability insurance and fiduciary liability insurance maintained by America Online rovided that Holdco (or any successor) may substitute therefor one or more policies of at least the same coverage and amounts containing terms and conditions which are, in the aggregate, no less advantageous to the insured) with respect to claims arising from facts or events that occurred on or before the Effective Time; provided, however, that in no event shall Holdco be required to expend in any one year an amount in excess of 200% of the annual premiums currently paid by America Online for such insurance; and, ,Qrovided further that if the annual premiums of such insurance coverage exceed such amount, Holdco shall be obligated to obtain a policy with the greatest coverage available for a cost not exceeding such amount. The obligations of Holdco under this Section 6.7(b) shall not be terminated or modified in such a manner as to adversely affect any indemnitee to whom this Section 6.7(b) applies without the consent of such affected indemnitee (it being expressly agreed that the indemnitees to whom this Section 6.7(b) applies shall be third party beneficiaries of this Section 6.7(b)). 6.8 Public Announcements. America Online and Time Warner shall use reasonable best efforts to develop a joint communications plan and each party shall use reasonable best efforts (i) to ensure that all press releases and other public statements with respect to the transactions contemplated hereby shall be consistent with such joint communications plan and (ii) unless otherwise required by applicable law or by obligations pursuant to any listing agreement with or rules of any securities exchange, to consult with each other before issuing any press release or, to the extent practical, otherwise making any public statement with respect to this Agreement or the transactions contemplated hereby. In addition to the foregoing, except to the extent disclosed in or consistent with the Joint Proxy Statement/Prospectus in accordance with the provisions of Section 6.1, neither America Online nor Time Warner shall issue any press release or otherwise make any public statement or disclosure concerning the other party or the other party's business, fmancial condition or results of operations without the consent of the other party, which consent shall not be unreasonably withheld or delayed. 6.9 Listing of Shares of Holdco Common Stock. Holdco shall use its reasonable best efforts to cause the shares of Holdco Common Stock to be issued in the Merger and the shares of Holdco Common Stock to be reserved for issuance upon exercise of the Time Warner Stock Options and America Online Stock Options to be approved for listing on the NYSE, subject to official notice of issuance, prior to the Closing Date. 6.10 Ri�hts Ag,reements. (a) The Board of Directors of America Online shall take all action to the extent necessary (including amending the America Online Rights Agreement) in order to render the America Online Rights inapplicable to the Anierica Online Merger and the other transactions contemplated by this Agreement and the Stock Option C03780-000�-0�26°-r.0! ?�Cn9-:!G'r. 54 Agreements. Except in connection with the foregoing sentence, the Board of Directors of America Online shall not, without the prior written consent of Time Warner, (i) amend the America Online Rights Agreement or (ii) take any action with respect to, or make any determination under, the America Online Rights Agreement, including a redemption of the America Online Rights, in each case in order to facilitate any Acquisition Proposal with respect to America Online. (b) The Board of Directors of Time Warner shall take all action to the extent necessary (including amending the Time Warner Rights Agreement) in order to render the Time Warner Rights inapplicable to the Time Warner Merger and the other transactions contemplated by this Agreement and the Stock Option Agreements. Except in connection with the foregoing sentence, the Board of Directors of Time Warner shall not, without the prior written consent of ' America Online, (i) amend the Time Warner Rights Agreement or (ii) take any action with respect to, or make any determination under, the Time Warner Rights Agreement, including a redemption of the Time Warner Rights, in each case in order to facilitate any Acquisition Proposal with respect to Time Warner. Notwithstanding the preceding sentence, Time Warner may, in its sole discretion, either resolve to redeem the Time Warner Rights effective as of, or amend the expiration date of the Time Warner Rights Agreement to provide that it terminates on, the close of business on the date of Time Warner's 2000 annual meeting of stockholders; nrovided, however, that if prior to, on, or following such date a person has (i) indicated (either publicly or in a manner which becomes known to America Online or Time Wamer) its intention to accumulate Time Warner Capital Stock other than for investment purposes, (ii) indicated (either publicly or in a manner which becomes known to America Online or Time Warner) its intention to make an Acquisition Proposal with respect to Time Warner or (iii) made an Acquisition Proposal with respect to Time Warner, then, upon the written request of America Online, Time Warner shall within 10 business days following such request take all action necessary to enter into a new stockholder rights plan no less favorable to Time Warner or America Online than the Time Warner Rights Agreement. Time Warner shall give America Online prompt notice of any information known by Time Warner with respect to the occurrence of an event set forth in clauses (i), (ii) and (iii) of the immediately preceding sentence. Upon the implementation of such new stockholder rights plan, Time Warner shall be subject to this Section 6.10(b) without giving effect to the immediately preceding sentence. 6.11 Affiliates. (a) Not less than 45 days prior to the date of the Time Warner Stockholders Meeting, Time Warner shall deliver to America Onlize a letter identifying all persons who, in the judgment of Time Warner, may be deemed at the time this Agreement is submitted for adoption by the stockholders of Time Warner, "affiliates" of Time Warner for purposes of Rule 145 under the Securities Act and applicable SEC rules and regulations, and such list shall be updated as necessary to reflect changes from the date thereof. Time Warner shall use reasonable best efforts to cause each person identified on such list to deliver to Holdco not less than 30 days prior to the GC3�S0-00�%-C2263-A016EC'r.9-?;�A SS Effective Time, a written agreement substantially in the form attached as Exhibit 6.11 hereto (an "Affiliate Agreement"). (b) Not less than 45 days prior to the date of the America Online Stockholders Meeting, America Online shall deliver to Time Warner a letter identifying all persons who, in the judgment of America Online, may be deemed at the time this Agreement is submitted for adoption by the stockholders of America Online, "affiliates" of America Online for purposes of Rule 145 under the Securities Act and applicable SEC rules and regulations, and such list shall be updated as necessary to reflect changes from the date thereof. America Online shall use reasonable best efforts to cause each person identified on such list to deliver to Holdco not less than 30 days prior to the Effective Time, an Affiliate Agreement. 6.12 Section 16 Matters. Prior to the Effective Time, America Online and Time Warner shall take all such steps as may be required to cause any dispositions of Time Warner Capital Stock or America Online Common Stock (including derivative securities with respect to Time Warner Capital Stock or America Online Common Stock) or acquisitions of Holdco Common Stock (including derivative securities with respect to Holdco Common Stock) resulting from the transactions contemplated by Article I or Article II of this Agreement by each individual who is subject to the reporting requirements of Section 16(a) of the Exchange Act with respect to America Online and Time Warner, to be exempt under Rule 16b-3 promulgated under the Exchange Act. 6.13 America Online Indebtedness and Time Warner Indebtedness. With respect to America Online Indebtedness and Time Warner Indebtedness issued under indentures qualified under the Trust Indenture Act of 1939, and any other America Online Indebtedness or Time Warner Indebtedness the terms of which require Holdco to assume such debt in order to avoid default thereunder (collectively, the "Assumed Indentures"), Holdco shall execute and deliver to the trustees or other representatives in accordance with the terms of the respective Assumed Indentures, supplemental indentures or other instruments, in form satisfactory to the respective trustees or other representatives, expressly assuming the obligations of America Online or Time Warner, as applicable, with respect to the due and punctual payment of the principal of (and premium, if any) and interest, if any, on, and conversion obligations under, all debt securities issued by America Online or Time Warner, as applicable, under the respective Assumed Indentures and the due and punctual performance of all the terms, covenants and conditions of the respective Assumed Indentures to be kept or performed by America Online or Time Warner, respectively, and shall deliver such supplemental indentures or other instruments to the respective trustees or other representatives under the Assumed Indentures. cc�;ec-cco�-e22E9-A01?c�'r.°-MvA 56 ARTICLE VII CONDITIONS PRECEDENT 7.1 Conditions to Each P 's Obligation to Effect its Respective Mer�. The respective obligations of Time Warner and America Online to effect the Time Warner Merger and America Online Merger are subject to the satisfaction or waiver on or prior to the Closing Date of the following conditions: (a) Stockholder A� rn oval. (i) Time Warner shall have obtained the Required Time Warner Vote in connection with the adoption of this Agreement by the stockholders of Time Warner and (ii) America Online shall have obtained the America Online Stockholder Approval in connection with the adoption of this Agreement by the stockholders of America Online. (b) No In�unctions or Restraints. Ille a� litv. No Laws shall have been adopted or promulgated, and no temporary restraining order, preliminary or permanent injunction or other order issued by a court or other Governmental Entity of competent jurisdiction shall be in effect, having the effect of making the Mergers illegal or otherwise prohibiting consummation of the Mergers. (c) HSR Act• EC Mer eg r Regulation• Canadian Investment Regulations. The waiting period (and any extension thereo fl applicable to the Mergers under the HSR Act shall have been terminated or shall have expired and any required approval of the Mergers of the European Commission or Canadian Governmental Entities shall have been obtained pursuant to the EC Merger Regulation and the Canadian Investment Regulations, respectively. (d) FCC A�provals. All material orders and approvals of the FCC required in connection with the consummation of the transactions contemplated hereby shall have been obtained and become final; provided, however, that the provisions of this Section 7.1(d) shall not be available to any party whose failure to fulfill its obligations pursuant to Section 6.4 has been the cause of, or shall have resulted in, the failure to obtain such order or approval. (e) Cable Franchising Authorities and PUCs Approvals. All consents, approvals and actions of, filings with and notices to any Cable Franchising Authorities or PUCs required of America Online, Time Warner or any of their Subsidiaries to consummate the Mergers and the other transactions contemplated hereby, the failure of which to be obtained or taken, individually or in the aggregate, would reasonably be expected to have a Material Adverse Effect on Holdco after giving effect to the Mergers, shall have been obtained; ro.� vided, however, that the provisions of this Section 7.1(e) shall not be available to any party whose failure to fulfill its obligations pursuant to Section 6.4 has been the cause of, or shall have resulted in, the failure to obtain such consent or approval or action. G037 �0-CC07-C2269-i.0i8EC'r.9-::Gn 57 ( fl NYSE Listin�. The shares of Holdco Common Stock to be issued in the Mergers and such other shares of Holdco Common Stock to be reserved for issuance in connection with the Mergers shall have been approved for listing on the NYSE, subject to official notice of issuance. (g) Effectiveness of the Form S-4. The Form S-4 shall have been declared effective by the SEC under the Securities Act and no stop order suspending the effectiveness of the Form S-4 shall have been issued by the SEC and no proceedings for that purpose shall have been initiated or threatened by the SEC. 7.2 Additional Conditions to Obligations of America Online. The obligations of America Online to effect the America Online Merger are subject to the satisfaction, or waiver by America Online, on or prior to the Closing Date of the following conditions: (a) Representations and Warranties. Each of the representations and warranties of Time Wamer set forth in this Agreement, disregarding all qualifications and exceptions contained therein relating to materiality or Material Adverse Effect, shall be true and correct as of the date of this Agreement and as of the Closing Date as though made on and as of the Closing Date (except to the extent that such representations and warranties speak as of another date, in which case such representations and warranties shall be true and correct as of such other date), except where the failure of such representations and warranties to be true and correct would not, individually or in the aggregate, reasonably be expected to have a Material Adverse Effect on Time Warner; and America Online shall have received a certificate of a senior executive officer and a senior financial officer of Time Warner to such effect. (b) Ferformance of Obl�ations of Time Warner. Time Wamer shall have performed or complied with all agreements and covenants required to be performed by it under this Agreement at or prior to the Closing Date that are qualified as to materiality or Material Adverse Effect and shall have performed or complied in all material respects with all other material agreements and covenants required to be performed by it under this Agreement at or prior to the Closing Date that are not so qualified, and America Online shall have received a certificate of a senior executive officer and a senior financial officer of Time Warner to such effect. (c) Tax O�inion. America Online shall have received from Simpson Thacher & Bartlett, counsel to America Online, on the Closing Date, a written opinion to the effect that for federal income tax purposes each Merger will constitute an exchange to which Section 351 of the Code applies or a reorganization within the meaning of Section 368(a) of the Code, or both. In rendering such opinion, counsel to America Online shall be entitled to rely upon information, representations and assumptions provided by Holdco, America Online and Time Warner substantially in the form of Exhibits 7.2(c)(1), 7.2(c)(2) and 7.2(c)(3) (allowing for CG3'•S�-�007-022E9-AOiBECF:9-"!GA 5 8 such amendments to the representations as counsel to America Online deems reasonably necessary). (d) Time Warner Conditions. The conditions set forth in Section 7.3 (other than Section 7.3(d)) shall have been satisfied or waived by Time Warner. '.3 Additional Conditions to Obligations of Time Wamer. The obligations of Time Warner to effect the Time Warner Merger are subject to the satisfaction, or waiver by Time Warner, on or prior to the Closing Date of the following additional conditions: (a) ReQresentations and Warranties. Each of the representations and warranties of America Online set forth in this Agreement, disregarding all qualifications and exceptions contained therein relating to materiality or Material Adverse Effect, shall be true and correct as of the date of this Agreement and as of the Closing Date as though made on and as of the Closing Date (except to the extent that such representations and warranties speak as of another date, in which case such representations and warranties shall be true and correct as of such other date), except where the failure of such representations and warranties to be true and correct would not, individually or in the aggregate, reasonably be expected to have a Material Adverse Effect on America Online; and Time Warner shall have received a certificate of a senior executive officer and a senior financial officer of America Online to such effect. (b) Performance of Obligations of America Online. America Online shall have performed or complied with all agreements and covenants required to be performed by it under this Agreement at or prior to the Closing Date that are qualified as to materiality or Material Adverse Effect and shall have performed or complied in all material respects with all other material agreements and covenants required to be performed by it under this Agreement at or prior to the Closing Date that are not so qualified, and Time Warner shall have received a certificate of a senior executive officer and a senior financial officer of America Online to such effect. (c) Tax O.pinion. Time Warner shall have received from Cravath, Swaine & Moore, counsel to Time Warner, on the Closing Date, a written opinion to the effect that for federal income tax purposes each Merger will constitute an exchange to which Section 351 of the Code applies or a reorganization within the meaning of Section 368(a) of the Code, or both. In rendering such opinion, counsel to Time Warner shall be entitled to rely upon information, representations and assumptions provided by Holdco, America Online and Time Wazner substantially in the form of Exhibits 7.2(c)(1), 7.2(c)(2) and 7.2(c)(3) (allowing for such amendments to the representations as counsel to Time Warner deems reasonably necessary). (d) America Online Conditions. The conditions set forth in Section 7.2 (other than 7.2(d)) shall have been satisfied or waived by America Online. 0037?C-�00%-C226�-i3O'_6=CE!9-vGi, 59 ARTICLE VIII TERMINATION AND AMENDMENT 8.1 Tennination. This Agreement may be terminated at any time prior to the Effective Time, by action taken or authorized by the Board of Directors of the terminating party or parties, and except as provided below, whether before or after approval of the matters presented in connection with the Mergers by the stockholders of Time Warner or America Online: (a) By mutual written consent of America Online and Time Warner; (b) By either Time Warner or America Online, if the Effective Time shall not have occurred on or before May 31, 2001 (the "Termination Date");.provided, however, that the right to terminate this Agreement under this Section 8.1(b) shall not be available to any pariy whose failure to fulfill any obligation under this Agreement (including without limitation such party's obligations set forth in Section 6.4) has been the cause of, or resuited in, the failure of the Effective Time to occur on or before the Termination Date; (c) By either Time Wamer or America Online, if any Governmental Entity (i) shall have issued an order, decree or ruling or taken any other action (which the parties shall have used their reasonable best efforts to resist, resolve or lift, as applicable, in accordance with Section 6.4) permanently restraining, enjoining or otherwise prohibiting the transactions contemplated by this Agreement, and such order, decree, ruling or other action shall have become final and nonappealable or (ii) shall have failed to issue an order, decree or ruling or to take any other action, and such denial of a request to issue such order, decree, ruling or take such other action shall have become final and nonappealable (which order, decree, ruling or other action the parties shall have used their reasonable best efforts to obtain, in accordance with Section 6.4), in the case of each of (i) and (ii) which is necessary to fulfill the conditions set forth in Sections 7.1(c), (d) or (e), as applicable; .Qrovided, however, that the right to terminate this Agreement under this Section 8.1(c) shall not be available to any party whose failure to comply with Section 6.4 has been the cause of such action or inaction; (d) By either Time Warner or America Online, if the approvals of the stockholders of either America Online or Time Warner contemplated by this Agreement shall not have been obtained by reason of the failure to obtain the required vote at a duly held meeting of stockholders or of any adjournment thereof at which the vote was taken; (e) By America Online, if Time Warner shall have (i) failed to make the Time Warner Recommendation or effected a Change in the Time Warner Recommendation (or resolved to take any such action), whether or not permitted by the terms hereof, or (ii) materially breached its obligations under this Agreement by reason of a failure to call the Time Warner Stockholders Meeting in accordance with Section 6.1(b) or a failure to prepare and mail to its stocl:holders the Joint Proxy Statement/Prospectus in accordance with Section 6.1(a); GC3i80-000?-C2265-r0iE5CH9-"=G=. 60 ( fl By Time Warner, if America Online shall have (i) failed to make the America Online Recommendation or effected a Change in the America Online Recommendation (or resolved to take any such action), whether or not permitted by the tenns hereof or (ii) materially breached its obligations under this Agreement by reason of a failure to call the America Online Stockholders Meeting in accordance with Section 6.1(c) or a failure to prepaze and mail to its stockholders the Joint Proxy Statement/Prospectus in accordance with Section 6.1(a); (g) By Time Warner, if America Online shall have breached or failed to perform any of its representations, warranties, covenants or other agreements contained in this Agreement, such that the conditions set forth in Section 7.3(a) or (b) are not capable of being satisfied on or before the Termination Date; or (h) By America Online, if Time Warner shall have breached or failed to perform any of its representations, warranties, covenants or other agreements contained in this Agreement, such that the conditions set forth in Section 7.2(a) or (b) are not capable of being satisfied on or before the Termination Date. 8.2 Effect of Termination. (a) In the event of termination of this Agreement by either Time Warner or America Online as provided in Section 8.1, this Agreement shall forthwith become void and there shall be no liability or obligation on the part of America Online or Time Warner or their respective officers or directors except with respect to Section 4.1(k), Section 4.2(k), the second sentence of Section 6.3, Section 6.6, this Section 8.2 and Article IX, which provisions shall survive such termination, and except that, notwithstanding anything to the contrary contained in this Agreement, neither America Online nor Time Warner shall be relieved or released from any liabilities or damages arising out of its wilful and material breach of this Agreement. (b) If (A) (I) either party shall terminate this Agreement pursuant to Section 8.1(d) (provided that the basis for such termination is the failure of Time Warner's stockholders to adopt this Agreement) or pursuant to Section 8.1(b) without the Time Warner Stockholder Meeting having occucred, (II) at any time after the date of this Agreement and before such termination an Acquisition Proposal with respect to Time Warner shall have been publicly announced or otherwise communicated to the senior management, Board of Directors or stockholders of Time Warner (a "Time Warner Public Progosal") and (III) within twelve months of such termination Time Warner or any of its Subsidiaries enters into any definitive agreement with respect to, or consummates, any Acquisition Proposal (for purposes of this clause (IIn, the term "Acquisition ProQosal" shall have the meaning assigned to such term in Section 6.5(a) except that references to "20%" therein shall be deemed to be references to "40%") or (B) America Online shall terminate this Agreement pursuant to Section 8.1(e); then Time Warner shall promptly, but in no event later than the date of such termination (or in the case of clause (A), if later, the date Time Warner or its Subsidiary enters into such agreement with respect to or consummates such Acquisition Proposal), pay America Online an amount equal to the Time b03790-0007-0226?-AO.EECE9-MGA 61 Warner Termination Fee, by wire transfer of immediately available funds (less any amounts previously paid or payable by Time Warner pursuant to Section 8.2(d)). The "Time Warner Termination Fee" shall be an amount equal to 2.75% of the product of (x) the number of shares of Time Warner Common Stock outstanding as of the date hereof (assuming the exercise of all outstanding options (other than the option granted pursuant to the Time Warner Stock Option Agreement) and the conversion into Time Warner Common Stock of all securities of Time Warner convertible into Time Wamer Common Stock) multiplied by (y) the Exchange Ratio multiplied by (z) the last sale price of America Online Common Stock on the NYSE on January 7, 2000 (such product, the "Time Warner AmounY'). (c} If (A) (I) either party shall terminate this Agreement pursuant to Section 8.1(d) (provided that the basis for such termination is the failure of America Online's stockholders to adopt this Agreement) or pursuant to Section 8.1(b) without the America Online Stockholders Meeting having occurred, (II) at any time after the date of this Agreement and before such termination an Acquisition Proposal with respect to America Online shall have been publicly announced or otherwise communicated to the senior management, Boazd of Directors or stockholders of America Online (an "America Online Public Proposal") and (III) within twelve months of such termination America Online or any of its Subsidiaries enters into any definitive agreement with respect to, or consummates, any Acquisition Proposal (for purposes of this clause (III), the term "Acc�uisition Proposal" shall have the meaning assigned to such term in Section 6.5(a) except that references to "20%" therein shall be deemed to be references to "40%") or (B) Time Warner shall terminate this Agreement pursuant to Section 8.1( fl; then America Online shall promptly, but in no event later than the date of such termination (or in the case of clause (A), if later, the date America Online or its Subsidiary enters into such agreement with respect to or consummates such Acquisition Proposal), pay Time Warner an amount equal to the America Online Termination Fee (less any amounts previously paid or payable by America Online pursuant to Section 8.2(d)), by wire transfer of immediately available funds. The "America Online Termination Fee" shall be an amount equal to 2.75% of the product of (x) the number of shares of America Online Common Stock outstanding as of the date hereof (assuming exercise of all outstanding options (other than the option granted pursuant to the America Online Stock Option Agreement) and the conversion into America Online Common Stock of all securities of America Online convertible into America Online Common Stock) multiplied by (y) the last sale price of America Online Common Stock on the NYSE on January 7, 2000 (such product, the "America Online Amount"). (d) If either party shall terminate this Agreement pursuant to Section S.1(d) and the basis for such termination is the failure of Time Warner's stockholders to adopt this Agreement), then Time Warner shall promptly, but in no event later than the date of such termination, pay America Online an amount equal to one percent of the Time Warner Amount, payable by wire transfer of immediately available funds; rop vided that no payment shall be made pursuant to this sentence if the Time Wamer Termination Fee has been paid pursuant to Section 82(b). If either party shall terminate this Agreement pursuant to Section 8.1(d) and the basis for such termination is the failure of America Online's stockholders to adopt this Agreement, then America Online shall promptly, but in no event later than the date of such termination, pay Time �03'_�-,_.,,-02269-AC! oEC!�9-VGP. 61' Warner an amount equal to one percent of the America Online Amount, payable by wire transfer of immediately available funds; rovi ed that no payment shall be made pursuant to this sentence if the America Online Termination Fee has been paid pursuant to Section 8.2(c). (e) The parties acknowledge that the agreements contained in this Section 8.2 are an integral part of the transactions contemplated by this Agreement, and that, without these agreements, neither party would enter into this Agreement; accordingly, if either party fails promptly to pay any amount due pursuant to this Section 8.2, and, in order to obtain such payment, the other party commences a suit which results in a judgment against such party for the fee set forth in this Section 8.2, such party shall pay to the other party its costs and expenses (including attorneys' fees and expenses) in connection with such suit, together with interest on the amount of the fee at the prime rate of Citibank, N.A. in effect on the date such payment was required to be made notwithstanding the provisions of Section 6.6. The parties agree that any remedy or amount payable pursuant to this Section 8.2 shall not preclude any other remedy or amount payable hereunder and shall not be an exclusive remedy for any breach of any representation, warranty, covenant or agreement contained in this Agreement. 8.3 Amendment. This Agreement may be amended by the parties hereto, by action taken or authorized by their respective Boards of Directors, at any time before or after approval of the matters presented in connection with the Mergers by the stockholders of Time Warner and America Online, but, after any such approval, no amendment shall be made which by law or in accordance with the rules of any relevant stock exchange requires further approval by such stockholders without such further approval. This Agreement may not be amended except by an instrument in writing signed on behalf of each of the parties hereto. 8.4 Extension: Waiver. At any time prior to the Effective Time, the parties hereto, by action taken or authorized by their respective Boards of Directors, may, to the extent legally allowed, (i) extend the time for the performance of any of the obligations or other acts of the other parties hereto, (ii) waive any inaccuracies in the representations and warranties contained herein or in any document delivered pursuant hereto and (iii) waive compliance with any of the agreements or conditions contained herein. Any agreement on the part of a pariy hereto to any such extension or waiver shall be valid only if set forth in a written instrument signed on behalf of such party. The failure of any party to this Agreement to assert any of its rights under this Agreement or otherwise shall not constitute a waiver of those rights. ARTICLE IX GENERAL PROVISIONS 9.1 Non-Survival of Representations Warranties and Agreements. None of the representations, warranties, covenants and other agreements in this Agreement or in any instrument delivered pursuant to this Agreement, including any rights arising out of any breach of such representations, warranties, covenants, agreements and other provisions, shall survive the 0037S0-COC7-02269-AOiBECY.9-:�:G;, 63 Effective Time, except for those covenants, agreements and other provisions contained herein (including Section 6.7, Section 6.2 and Schedule 6.2(a)) that by their terms apply or aze to be performed in whole or in part after the Effective Time and this Article IX. 9.2 Notices. All notices and other communications hereunder shall be in writing and shall be deemed duly given (a) on the date of delivery if delivered personally, or by telecopy or telefacsimile, upon confirmation of receipt, (b) on the first Business Day following the date of dispatch if delivered by a recognized next-day courier service, or (c) on the tenth Business Day following the date of mailing if delivered by registered or certified mail, return receipt requested, postage prepaid. All notices hereunder shall be delivered as set forth below, or pursuant to such other instructions as may be designated in writing by the party to receive such notice: (a) if to America Online to: America Online, Inc. 22000 AOL Way Dulles, Virginia 20166 Fax: (703) 265-1495 Attention: Paul T. Cappuccio, Esq. with a copy to: Simpson Thacher & Bartlett 425 Lexington Avenue New York, New York 10017 Fax: (212) 455-2502 Attention: Richard I. Beattie, Esq. (b) if to Time Warner to: Time Warner Inc. 75 Rockefeller Plaza New York, NY 10019 Fax: (212) 265-2646 Attention: Christopher P. Bogart, Esq. 0�37SJ-CCO'-02269-;,C1?SC�9-�:G;, C)4 with a copy to: Cravath, Swaine & Moore Worldwide Plaza 825 Eighth Avenue New York, New York 10019 Fax: (212) 474-3700 Attention: Robert A. Kindler, Esq. 9.3 Inter�retation. When a reference is made in this Agreement to Articles, Sections, Exhibits or Schedules, such reference shall be to an Article or Section of or Exhibit or Schedule to this Agreement unless otherwise indicated. The table of contents and headings contained in this Agreement are for reference purposes only and shall not affect in any way the meaning or interpretation of this Agreement. Whenever the words "include," "includes" or "including" are used in this Agreement, they shall be deemed to be followed by the words "without limitation." In addition, each Section of this Agreement is qualified by the matters set forth with respect to such Section on the America Online Disclosure Schedule, the Time Warner Disclosure Schedule and the Schedules to this Agreement, as applicable, to the extent specified therein and such other Sections of this Agreement to the extent a matter in such Section is disclosed in such a way as to make its relevance called for by such other Section readily appazent. 9.4 Counterparts. This Agreement may be executed in one or more counterparts, all of which shall be considered one and the same agreement and shall become effective when one or more counterparts have been signed by each of the parties and delivered to the other party, it being understood that both parties need not sign the same counterpart. 9.5 Entire A,greement; No Third Partv Beneficiaries. (a) This Agreement, the Stock Option Agreements, the Confidentiality Agreement and the exhibits and schedules hereto and the other agreements and instruments of the parties delivered in connection herewith constitute the entire agreement and supersede all prior agreements and understandings, both written and oral, among the parties with respect to the subject matter hereof. (b) This Agreement shall be binding upon and inure solely to the benefit of each party hereto, and nothing in this Agreement, express or implied, is intended to or shall confer upon any other Person any right, benefit or rsmedy of any nature whatsoever under or by reason of this Agreement, other than Section 6.7 (which is intended to be for the benefit of the Persons covered thereby). 9.6 Governing Law. This Agreement shall be governed an� construed in accordance with the laws of the State of Delaware (without giving effect to choice of law principles thereo�. CC37oC—�OC%-02269—A018ECri9—MG?. 65 9.7 Severabilitv. If any term or other provision of this Agreement is invalid, illegal or incapable of being enforced by any law or public policy, all other terms and provisions of this Agreement shall nevertheless remain in full force and effect so long as the economic or legal substance of the transactions contemplated hereby is not affected in any manner materially adverse to any party. Upon such determination that any term or other provision is invalid, illegal or incapable of being enforced, the parties hereto shall negotiate in good faith to modify this Agreement so as to effect the original intent of the parties as closely as possible in an acceptable manner in order that the transactions contemplated hereby are consummated as originally contemplated to the greatest extent possible. 9.8 Assignment. Neither this Agreement nor any of the rights, interests or obligations hereunder shall be assigned by any of the parties hereto, in whole or in part (whether by operation of law or otherwise), without the prior written consent of the other party, and any attempt to make any such assignment without such consent shall be null and void. Subject to the preceding sentence, this Agreement will be binding upon, inure to the benefit of and be enforceable by the parties and their respective successors and assigns. 9.9 Submission to Jurisdiction: Waivets. Each of America Online and Time Warner irrevocably agrees that any legal action or proceeding with respect to this Agreement or for recognition and enforcement of any judgment in respect hereof brought by the other party hereto or its successors or assigns may be brought and determined in the Chancery or other Courts of the State of Delaware, and each of America Online and Time Warner hereby irrevocably submits with regard to any such action or proceeding for itself and in respect to its property, generally and unconditionally, to the nonexclusive jurisdiction of the aforesaid courts. Each of America Online and Time Warner hereby irrevocably waives, and agrees not to assert, by way of motion, as a defense, counterclaim or otherwise, in any action or proceeding with respect to this Agreement, (a) any claim that it is not personally subject to the jurisdiction of the above-named courts for any reason other than the failure to lawfully serve process (b) that it or its property is exempt or irnmune from jurisdiction of any such court or from any legal process commenced in such courts (whether through service of notice, attachment prior to judgment, attachment in aid of execution of judgment, execution of judgment or otherwise), (c) to the fullest extent permitted by applicable law, that (i) the suit, action or proceeding in any such court is brought in an inconvenient forum, (ii) the venue of such suit, action or proceeding is improper and (iii) this Agreement, or the subject matter hereof, may not be enforced in or by such courts and (d) any right to a trial by jury. 9.10 Enforcement. The parties agree that irreparable damage would occur in the event that any of the provisions of this Agreement were not performed in accordance with their specific ternis. It is accordingly agreed that the parties shall be entitled to specific performance of the terms hereof, this being in addition to any other remedy to which they are entitled at law or in equity. G03790-000%-02269-AOlEECH9-MGA 66 9.11 Definitions. As used in this Agreement: (a) "beneficial ownershin" or "beneficially own" shall have the meaning under Section 13(d) of the Exchange Act and the rules and regulations thereunder. (b) "Benefit Plans" means, with respect to any Person, each employee benefit plan, program, arrangement and contract (including, without limitation, any "employee benefit plan," as defined in Section 3(3) of the Employee Retirement Income Security Act of 1974, as amended ("ERISA") and any bonus, deferred compensation, stock bonus, stock purchase, restricted stock, stock option, employment, termination, stay agreement or bonus, change in control and severance plan, program, arrangement and contract) in effect on the date of this Agreement or disclosed on the Time Warner Disclosure Schedule or the America Online Disclosure Schedule, as the case may be, to which such Person or its Subsidiary is a party, which is maintained or contributed to by such Person, or with respect to which such Person could incur material liability under Sections 4069, 4201 or 4212(c) of ERISA. (c) "Board of Directors" means the Board of Directors of any specified Person and any committees thereof. (d) "Business Dav" means any day on which banks are not required or authorized to close in the City of New York. (e) "known" or "knowledee" means, with respect to any party, the knowledge of such party's executive officers after reasonable inquiry. (� "Material Adverse Effect" means, with respect to any entity any event, change, circumstance or effect that is or is reasonably likely to be materially adverse to (i) the business, financial condition or results of operations of such entity and its Subsidiaries taken as a whole, other than any event, change, circumstance or effect relating (x) to the economy or financial markets in general or (y) in general to the industries in which such entity operates and not specifically relating to (or having the effect of specifically relating to or having a materially disproportionate effect (relative to most other industry participants) on) such entity or (ii) the ability of such entity to consummate the transactions contemplated by this Agreement. (g) "the other partv" means, with respect to Time Warner, America Online and means, with respect to America Online, Time Wamer. (h) "Person" means an individual, corporation, limited liability company, partnership, association, trust, unincorporated organization, other entity or group (as defined in the Exchange Act). (i) "Subsidiarv" when used with respect to any party means any corporation or other organization, whether incorporated or unincorporated, at least a majority of the securities or other interests of which having by their terms ordinary voting power to elect a majority of the GG3720-CC07-�2265-�Oi8EC-9_MGA 67 Board of Directors or others performing similar functions with respect to such corporation or other organization is directly or indirectly owned or controlled by such party or by any one or more of its Subsidiaries, or by such party and one or more of its Subsidiaries. For the avoidance of doubt, TWE and TWE-AN Partnership shall be considered a Subsidiary of Time Warner. C�'J7'IGC'.�..ri� '�ZLC7-.�.'�ZG":'G_VCn �V IN WITI�TESS WHEREOF, America Online and Time Wamer have caused this Agreement to be signed by their respective officers thereunto duly authorized, all as of the date first written above. AMERICA ONL , INC. By: Name: Stephen M. Case Title: Chairman & Chief Executive Officer TIME WARNER Ilv C. By: Name: Title: I�' ��'iT1�FSS ti��HEREOF, .�merica Online and Time W"amer have cawed this �,�re�i�znt to be si�ed by their respec,`ti�,'a officers thereunto duly authorized, a11 as of th� dace �r,t wri:ten above. �,?�iEP�ICA O�.LIN�E, I�C- $v: N�me: Title: TZ:vI� E�'AR�iER INC. Bti': �,�/ . Name: Title: EXECUTION COPY STOCK OPTION AGREEMENT, dated as of January 10, 2000 (the "AQreement"), between America Online, Inc., a Delaware corporation (" r ntee"), and Time Warner Inc., a Delaware corporation ("Issuer"). WITNESSETH: WHEREAS, Grantee and Issuer are, concurrently with the execution and delivery of this Agreement, entering into an Agreement and Plan of Merger, dated as of the date hereof (the "Merger Agr�eement;" capitalized terms used without definition herein having the meanings assigned to them in the Merger Agreement), pursuant to which the parties will engage in a business combination in a merger of equals (the "Mer er"); and WHEREAS, as a condition to their willingness to enter into the Merger Agreement, Grantee has required that Issuer agree, and believing it to be in the best interests of Issuer, Issuer has agreed, among other things, to grant to Grantee the Option (as hereinafter defined) to purchase shares of common stock, par value �.01 per share, of Issuer ("Issuer Common Stock") at a price per share equal to the Exercise Price (as hereinafter defined). NOW THEREFORE, in consideration of the foregoing and the mutual representations, warranties, covenants and agreements herein contained, and intending to be legally bound hereby, the parties hereto agree as follows: ARTICLE I OPTION TO PURCHASE SHARES 1.1 Grant of O�ion. (a) Issuer hereby grants to Grantee an irrevocable option to purchase, in whole or in part, an aggregate of up to 233,263,204 duly authorized, validly issued, fully paid and nonassessable shares of Issuer Common Stock (representing 19.9% of the outstanding shares of Issuer Common Stock as of November 30, 1999) on the terms and subject to the conditions set forth herein (the "Ontion"); provided, however, that in no event shall the number of shares of Issuer Common Stock for which this Option is exercisable exceed 19.9% of the issued and outstanding shares of Issuer Common Stock at the time of exercise without giving effect to the issuance of any Option Shares (as hereinafter defined). The number of shares of Issuer Common Stock that may be received upon the exercise of the Option and the Exercise Price are subject to adjustment as herein set forth. (b) In the event that any additional shares of Issuer Common Stock are issued or other�vise become outstanding after the date of this Agreement (other than pursuant to this Agreement and other than pursuant to an event described in Section 3.1 hereo fl, the number of shares of Issuer Common Stock subject to the Option shall be increased so that, after such issuance, such number together with any shares of Issuer Common Stock previously issued ��:,s�-�� -�zs��-��__==�.;a-ac� � pursuant hereto, equals 19.9% of the number of shares of Issuer Common Stock then issued and outstanding without giving effect to any shares subject or issued pursuant to the Option. Nothing contained in this Section 1.1(b) or elsewhere in this Agreement shall be deemed to authorize Issuer to breach or fail to comply with any provision of the Merger Agreement. As used herein, the term "Ontion Shares" means the shares of Issuer Common Stock issuable pursuant to the Option, as the number of such shares shall be adjusted pursuant to the terms hereof. 1.2 Exercise of O�tion. (a) The Option may be exercised by Grantee, in whole or in part, at any time, or from time to time, commencing upon the Exercise Date and prior to the Expiration Date. As used herein, the term "Exercise Date" means the date on which Grantee becomes unconditionally entitled to receive the Time Warner Termination Fee pursuant to Section 8.2(b) of the Merger Agreement. As used herein, the term "Ex�iration Date" means the first to occur prior to Grantee's exercise of the Option pursuant to Section 1.2(b) of: Issuer; (i) the Effective Time; (ii) written notice of termination of this Agreement by Grantee to (iii) 12 months after the first occutrence of an Exercise Date; or (iv) the date of termination of the Merger Agreement, unless, in the case of this clause (iv), Grantee has the right to receive the Time Warner Termination Fee either (x) upon or (y) following such termination upon the occurrence of certain events, in which case the Option will not terminate until the later of (x) 15 business days following the time the Time Warner Termination Fee becomes unconditionally payable and (y) the expiration of the period in which Grantee has such right to receive the Time Warner Termination Fee. Not�vithstanding the termination of the Option, Grantee shall be entitled to purchase those Option Shares with respect to which it may have exercised the Option by delivery of an Option Notice (as defined below) prior to the Expiration Date, and the termination of the Option will not affect any rights hereunder �vhich by their terms do not terminate or expire prior to or at the Expiration Date. (b) In the event Grantee wishes to exercise the Option, Grantee shall send a written notice to Issuer of its intention to so exercise the Option (an "Option Notice"), specifying the number of Option Shares to be purchased (and the denominations of the certificates, if more than one), whether the aggregate Exercise Price will be paid in cash or by surrendering a portion of the Option in accordance with Section 1.3(b) or a combination thereof, and the place in the United States, time and date of the closing of such purchase (the "O ti n Closina" and the date of such Closing, the "Option Closine, Date"), which date shall not be less than two Business Days nor more than ten Business Days from the date on which an Option _�?'�..-.,�.--02e39-993F°DJ4-nGR Notice is delivered; �rovided that the Option Closing shall be held only if (i) such purchase would not otherwise violate or cause the violation of, any applicable material law, statute, ordinance, rule or regulation (collectively, "Laws") (including the HSR Act and the Communications Act), and (ii) no material judg�nent, order, writ, injunction, ruling or decree of any Governmental Entity (collectively, " rders") shall have been promulgated, enacted, entered into, or enforced by any Governmental Entity which prohibits delivery of the Option Shazes, whether temporary, preliminary or permanent; r vide , however, that the parties hereto shall use their reasonable best efforts to (x) promptly make and process all necessary filings and applications and obtain all consents, approvals, Orders, authorizations, registrations and declarations or expiration or termination of any required waiting periods (collectively, "Apnrovals") and to comply with any such applicable Laws and (y) have any such Order vacated or reversed. In the event the Option Closing is delayed pursuant to clause (i) or (ii) above, the Option Closing shall be within ten Business Days following the cessation of such restriction, violation, Law or Order or the receipt of any necessary Approval, as the case may be (so long as the Option Notice was delivered prior to the Expiration Date); �rovided further that, notwithstanding any prior Option Notice, Grantee shall be entitled to rescind such Option Notice and shall not be obligated to purchase any Option Shares in connection with such exercise upon ��ritten notice to such effect to Issuer. (c) At any Option Closing, (i) Issuer shall deliver to Grantee all of the Option Shares to be purchased by delivery of a certificate or certificates evidencing such Option Shares in the denominations designated by Grantee in the Option Notice, and (ii) if the Option is exercised in part and/or surrendered in part to pay the aggregate Exercise Price pursuant to Section 1.3(b), Issuer and Grantee shall execute and deliver an amendment to this Agreement reflecting the Option Shares for which the Option has not been exercised and/or surrendered. If at the time of issuance of any Option Shares pursuant to an exercise of all or part of the Option hereunder, Issuer shall have issued any rights or other securities which are attached to or otherwise associated with the Issuer Common Stock, then each Option Share issued pursuant to such exercise shall also represent such rights or other securities with terms substantially the same as and at least as favorable to Grantee as are provided under any shareholder rights agreement or similar agreement of Issuer then in effect. At the Option Closing, Grantee shall pay to Issuer by wire transfer of immediately available funds to an account specified by Issuer to Grantee in writing at least two Business Days prior to the Option Closing an amount equal to the Exercise Price multiplied by the number of Option Shares to be purchased for cash pursuant to this Article I; Qrovided that the failure or refusal of Issuer to specify an account shall not affect Issuer's obligation to issue the Option Shares. (d) Upon the delivery by Grantee to Issuer of the Option Notice and the tender of the applicable aggregate Exercise Price in immediately available funds or the requisite portion of the Option in accordance with Section 1.3, Grantee shall be deemed to be the holder of record of the Option Shares issuable upon such exercise, notwithstanding that the stock transfer books of Issuer may then be closed, that certificates representing such Option Shares may not then have been actually delivered to Grantee, or Issuer may have failed or refused to take any action required of it hereunder. Issuer shall pay all expenses that may be payable in coru�ection �vith the preparation, issuance and delivery of stock certificates or an amendment to ��-.,,,-�,,.--�zs.�-�,�-_.,.,..-:,c� 4 this Agreement under this Section 1.2 and any filing fees and other expenses arising from the performance of the transactions contemplated hereby. 1.3 Payments. (a) The purchase and sale of the Option Shares pursuant to Section 1.2 of this Agreement shall be at a purchase price equal to $110.63 per Share (as such amount may be adjusted pursuant to the terms hereof, the "Exercise Price"), payable at Grantee's option in cash, by surrender of a portion of the Option in accordance with Section 1.3(b), or a combination thereof. (b) Grantee may elect to purchase Option Shares issuable, and pay some or all of the aggregate Exercise Price payable, upon an exercise of the Option by surrendering a portion of the Option with respect to such number of Option Shares as is determined by dividing (i) the aggregate Exercise Price payable in respect of the number of Option Shares being purchased in such manner by (ii) the excess of the Fair Market Value (as defined below) per share of Issuer Common Stock as of the last trading day preceding the date Grantee delivers its Option Notice (such date, the "Ontion Exercise Date") over the per share Exercise Price. The "Fair Market Value" per share of Issuer Common Stock shall be (i) if the Issuer Common Stock is listed on the New York Stock Exchange, Inc. (the "NYSE") or any other nationally recognized exchange or trading system as of the Option Exercise Date, the average of last reported sale prices per share of Issuer Common Stock thereon for the 10 trading days commencing on the 12`h trading day immediately preceding the Option Exercise Date, or (ii) if the Issuer Common Stock is not listed on the NYSE or any other nationally recognized exchange or trading system as of the Option Exercise Date, the amount determined by a mutually acceptable independent investment banking firm as the value per share the Issuer Common Stock would have if publicly traded on a nationally recognized exchange or trading system (assuming no discount for minority interest, illiquidity or restrictions on transfer). That portion of the Option so surrendered under this Section 1.3(b) shall be canceled and shall thereafter be of no further force and effect. (c) Certificates for the Option Shares delivered at an Option Closing will have typed or printed thereon a restrictive legend which will read substantially as follows: "THE SECURITIES REPRESENTED BY THIS CERTIFICATE HAVE NOT BEEN REGISTERED UNDER THE SECURITIES ACT OF 1933, AS AMENDED, AND MAY BE REOFFERED OR SOLD ONLY Ir' SO REGISTERED OR IF AN EXEMPTION FROM SUCH REGISTR.ATION IS AVAILABLE. SUCH SECURITIES ARE ALSO SUBJECT TO ADDITIONAL RESTRICTIONS ON TRANSFER AS SET FORTH IN THE STOCK OPTION AGREEMENT DATED AS OF JANUARY 10, 2000, A COPY OF WHICH MAY BE OBTAINED FROM THE SECRETARY OF TIME WARNER INC. AT ITS PRINCIPAL EXECUTIVE OFFICES." It is understood and agreed that (i) the reference to restrictions arising under the Securities Act in the above legend will be removed by delivery of substitute certificate(s) without such reference if �^3-4C-�.�7-�2939-99°_F?DJs-AGR such Option Shares have been registered pursuant to the Securities Act, such Option Shares have been sold in reliance on and in accordance with Rule 144 under the Securities Act or Grantee has delivered to Issuer a copy of a letter from the staff of the SEC, or an opinion of counsel in form and substance reasonably satisfactory to Issuer and its counsel, to the effect that such legend is nat required for purposes of the Securities Act and (ii) the reference to restrictions pursuant to this Agreement in the above legend will be removed by delivery of substitute certificate(s) without such reference if the Option Shares evidenced by certificate(s) containing such reference have been sold or transferred in compliance with the provisions of this Agreement under circumstances that do not require the retention of such reference. ARTICLE II REPRESENTATIONS AND WARRANTIES 2.1 Representations and Warranties of Grantee. Grantee hereby represents and warrants to Issuer that any Option Shares or other securities acquired by Grantee upon exercise of the Option �vill not be taken �vith a vie�v to the public distribution thereof and will not be transferred or otherwise disposed of except in a transaction registered or exempt from registration under the Securities Act. 2.2 Reoresentations and Warranties of Issuer. Issuer hereby represents and warrants to Grantee as follows: (a) Qntion Shares. Issuer has taken all necessary corporate and other action to authorize and reserve for issuance, and, subject to receipt of any Approvals, to permit it to issue, the Option Shares and all additional shares or other securities which may be issued pursuant to Section 3.1 upon exercise of the Option, and, at all times from the date hereof until such time as the obligation to deliver Option Shares hereunder terminates, will have reserved for issuance upon exercise of the Option the Option Shares and such other additional shares or securities, if any. All of the Option Shares and all additional shares or other securities or property which may be issuable pursuant to Section 3.1, upon exercise of the Option and issuance pursuant hereto, shall be duly authorized, validly issued, fully paid and nonassessable, shall be delivered free and clear of all Liens of any nature whatsoever, and shall not be subject to any preemptive or similar right of any Person. (b) No Restrictions. No Delaware law or other takeover statute or similar Law and no provision of the Restated Certificate of Incorporation or Bylaws of Issuer or any agreement to which Issuer is a party (a) would or would purport to impose restrictions which mi�ht adversely affect or delay the consummation of the transactions contemplated by this Agreement, or (b) as a result of the consummation of the transactions contemplaied by this 1A�reement, (i) «�ould or would purport to restrict or impair the ability of Grantee to vote or other«-ise exercise the rights of a shareholder �vith respect to securities of Issuer or any of its Subsidiaries that may be acquired or controlled by Grantee or (ii) would or would purport to entitle any Person to acquire securities of Issuer. �,._.c_-��C7-0?939-9°3?'rDJ4-.',GR G ARTICLE III ADJUSTMENT UPON CHANGES IN CAPITALIZATION 3.1 Ad�ustment U�on Changes in Capitalization. In addition to the adjustment in the number of shares of Issuer Common Stock that may be purchased upon exercise of the Option pursuant to Section 1.1 of this Agreement, the number of shares of Issuer Common Stock that may be purchased upon the exercise of the Option and the Exercise Price shall be subject to adjustment from time to time as provided in this Section 3.1. In the event of any change in the number of issued and outstanding shares of Issuer Common Stock by reason of any stock dividend; split-up, merger, recapitalization, combination, conversion, exchange of shares, spin- off or other change in the corporate or capital structure of Issuer which would have the effect of diluting or othenvise diminishing Grantee's rights hereunder, the number and kind of Option Shares or other securities subject to the Option and the Exercise Price therefor shall be appropriately adjusted so that Grantee shall receive upon exercise of the Option (or, if such a chan�e occurs between exercise and the Option Closing, upon the Option Closing) the number and kind of shares or other securities or property that Grantee would have received in respect of the Option Shares that Grantee is entitled to purchase upon exercise of the Option if the Option had been exercised (or the purchase thereunder had been consummated, as the case may be) immediately prior to such event or the record date for such event, as applicable. The rights of Grantee under this Section shall be in addition to, and shall in no way limit, its rights against Issuer for breach of or the failure to perfonn any provision of the Merger Agreement. ARTICLE IV REGISTRATION RIGHTS 4.1 Re�istration of Option Shares Under the Securities Act. (a) If requested by Grantee at any time and from time to time within two years after receipt by Grantee of Option Shares (the "Registration Period"), Issuer shall use its reasonable best efforts, as promptly as practicable, to effect the registration under the Securities Act and any applicable state law (a "Demand Re.gistration") of such number of Option Shares or such other Issuer securities owned by or issuable to Grantee in accordance with the method of sale or other disposition contemplated by Grantee, including a"shelf' registration statement under Rule 415 of the Securities Act or any successor provision, and to obtain all consents or waivers of other parties that are required therefor. Grantee agrees to use reasonable best efforts to cause, and to use reasonable best efforts to cause any underwriters of any sale or other disposition to cause, any sale or other disposition pursuant to such registration statement to be effected on a�;�idely distributed basis so that upon consummation thereof no purchaser or transferee will o�vn beneficially more than 3% of the then-outstanding voting power of Issuer. EYCept «�ith respect to such a"shelf' registration, Issuer shall keep such Demand Registration effective for a period of not less than 150 days, unless, in the written opinion of counsel to Issuer, C��7? -,,,,:'7-�233?-993F?DJ4-r,GR � which opinion shall be delivered to Grantee and which shall be satisfactory in form and substance to Grantee and its counsel, such registration under the Securities Act is not required in order to lawfully sell and distribute such Option Shares or other Issuer securities in the manner contemplated by Grantee. Issuer shall only have the obligation to effect three Demand Registrations pursuant to this Section 4.1; provided that only requests relating to a registration statement that has become effective under the Securities Act shall be counted for purposes of detennining the number of Demand Registrations made. Issuer shall be entitled to postpone for up to 150 days from receipt of Grantee's request for a Demand Registration the filing of any registration statement in connection therewith if the Board of Directors of Issuer determines in its good faith reasonable judgment that such registration would materially interFere with or require premature disclosure of, any material acquisition, reorganization, pending or proposed offering of Issuer Securities or other transaction involving Issuer or any other material contract under active negotiation by Issuer; and �rovided further that Issuer shall not have postponed any Demand Registration pursuant to this sentence during the twelve month period immediately preceding the date of delivery of Grantee's request for a Demand Registration. (b) If Issuer effects a registration under the Securities Act of Issuer Common Stock for its own account or for any other stockholders of Issuer (other than on Form S-4 or Form S-8, or any successor form), Grantee shall have the right to participate in such registration and include in such registration the number of shares of Issuer Common Stock or sueh other Issuer securities as Grantee shall designate by notice to Issuer (an "Incidental Re�istration" and, together with a Demand Registration, a"Re�istration"); �rovided, however, that, if the managing underwriters of such offering advise Issuer in writing that in their opinion the number of shares of Issuer Common Stock or other securities requested to be included in such Incidental Registration exceeds the number which can be sold in such offering, Issuer shall include therein (i) first, all shares proposed to be included therein by Issuer, (ii) second, subject to the rights of any other holders of registration rights in effect as of the date hereof, the shares requested to be included therein by Grantee and (iii) third, shares proposed to be included therein by any other stockholder of Issuer. Participation by Grantee in any Incidental Registration shall not affect the obligation of Issuer to effect Demand Registrations under this Section 4.1. Issuer may withdraw any registration under the Securities Act that gives rise to an Incidental Registration without the consent of Grantee. (c) In connection with any Registration pursuant to this Section 4.1, (i) Issuer and Grantee shall provide each other and any underwriter of the offering with customary representations, warranties, covenants, indemnification and contribution obligations in connection with such Registration, and (ii) Issuer shall use reasonable best efforts to cause any Option Shares included in such Registration to be approved for listing on the NYSE or any other nationally recognized exchange or trading system upon which Issuer's securities are then listed, subject to official notice of issuance, which notice shall be given by Issuer upon issuance. Grantee will provide all information reasonably requested by Issuer for inclusion in any registration statement to be filed hereunder. The costs and expenses incurred by Issuer in connection with any Re�istration pursuant to this Section 4.1 (including any fees related to qualifications under Blue Sky La�vs and SEC filing fees) (the "ReQistration Ex�enses") shall be �G3': ,-_,.,,-OiE39-09BF?D.7S-�-.�� borne by Issuer, excluding legal fees of Grantee's counsel and unden��riting discounts or commissions �vith respect to Option Shares to be sold by Grantee included in a Registration. 4.2 Transfers of Ontion Shares. The Option Shares may not be sold, assigned, transferred, or otherwise disposed of except (i) in an underwritten public offering as provided in Section 4.1 or (ii) to any purchaser of transferee who would not, to the knowledge of the Grantee after reasonable inquiry, immediately following such sale, assignment, transfer or disposal beneficially own more than 3% of the then-outstanding voting power of the Issuer; nrovided, however, that Grantee shall be permitted to sell any Option Shares if such sale is made pursuant to a tender or exchange offer that has been approved or recommended by a majority of the members of the Board of Directors of Issuer (which majority shall include a majority of directors who were directors as of the date hereo fl. ARTICLE V REPURCHASE RIGHTS; SUBSTITUTE OPTIONS 5.1 Repurchase Ri�hts. (a) Subject to Section 6.1, at any time on or after the Exercise Date and prior to the Expiration Date, Grantee shall have the right (the "Renurchase Right") to require Issuer to repurchase from Grantee (i) the Option or any part thereof as Grantee shall designate at a price (the "Ontion Re�urchase Price") equal to the amount, subject to reduction at the sole discretion of Grantee pursuant to clause (iii) of Section 6.1(a), by which (A) the Market/Offer Price (as defined below) exceeds (B) the Exercise Price, multiplied by the number of Option Shares as to which the Option is to be repurchased and (ii) such number of Option Shazes as Grantee shall designate at a price (the "Qption Share Repurchase Price") equal to the Market/Offer Price multiplied by the number of Option Shares so designated. The term "Market/Offer Price" shall mean the highest of (i) the highest price per share of Issuer Common Stock offered or paid in any Acquisition Proposal, or (ii) the highest closing price for shares of Issuer Common Stock during the six-month period immediately preceding the date Grantee gives the Repurchase Notice (as hereinafter defined). In determining the Market/Offer Price, the value of consideration other than cash shall be determined by a nationally recognized investment banking firm selected by Grantee and reasonably acceptable to Issuer, which determination, absent manifest error, shall be conclusive for all purposes of this Agreement. (b) Grantee shall exercise its Repurchase Right by delivering to Issuer �vritten notice (a "Re�.urchase Notice") stating that Grantee elects to require Issuer to repurchase all or a portion of the Option and/or the Option Shares as specified therein. The closing of the Repurchase Right (the "Renurchase Closins") shall take place in the United States at the place, time and date specified in the Repurchase Notice, �vhich date shall not be less than two Business Days nor more than ten Business Days from the date on which the Repurchase Notice is delivered. At the Repurchase Closing, subject to the receipt of a writing evidencing the surrender of the Option and/or certificates representing Option Shares, as the case may be, Issuer shall ,;,.-;,, - ,, :7-�263°-993F?JJ4-AGR 0 deliver to Grantee the Option Repurchase Price therefor or the Option Share Repurchase Price therefor, as the case may be, or the portion thereof that Issuer is not then prohibited under applicable Law from so delivering. At the Repurchase Closing, (i) Issuer shall pay to Grantee the Option Repurchase Price for the portion of the Option which is to be repurchased or the Option Shares Repurchase Price for the number of Option Shares to be repurchased, as the case may be, by wire transfer of immediately available funds to an account specified by Grantee at least 24 hours prior to the Repurchase Closing and (ii) if the Option is repurchased only in part, Issuer and Grantee shall execute and deliver an amendment to this Agreement reflecting the Option Shares for which the Option is not being repurchased. (c) To the extent that Issuer is prohibited under applicable Law from repurchasing the portion of the Option or the Option Shares designated in such Repurchase Notice, Issuer shall immediately so notify Grantee and thereafter deliver, from time to time, to Grantee the portion of the Option Repurchase Price and the Option Share Repurchase Price, respectively, that it is no longer prohibited from delivering, within five Business Days after the date on which Issuer is no longer so prohibited; provided, however, that if Issuer at any time after delivery of a Repurchase Notice is prohibited under applicable Law from delivering to Grantee the full amount of the Option Repurchase Price and the Option Share Repurchase Price for the Option or Option Shares to be repurchased, respectively, Grantee may rescind the exercise of the Repurchase Right, whether in whole, in part or to the extent of the prohibition, and, to the extent rescinded, no part of the amounts, terms or the rights with respect to the Option or Repurchase Right shall be changed or affected as if such Repurchase Right were not exercised. Issuer shall use its reasonable best efforts to obtain all required regulatory and legal approvals and to file any required notices to pennit Grantee to exercise its Repurchase Right and shall use its reasonable best efforts to avoid or cause to be rescinded or rendered inapplicable any prohibition on Issuer's repurchase of the Option or the Option Shares. 5.2 Substitute Option. (a) In the event that Issuer enters into an agreement (i) to consolidate with or merge into any Person, other than Grantee or any Subsidiary of Grantee (each an "Excluded Person"), and Issuer is not the continuing or surviving corporation of such consolidation or merger, (ii) to permit any Person, other than an Excluded Person, to merge into Issuer and Issuer shall be the continuing or surviving or acquiring corporation, but, in connection with such merger, the then outstanding shares of Issuer Common Stock shall be changed into or exchanged for stock or other securities of any other Person or cash or any other property or the then outstanding shares of Issuer Common Stock shall after such merger represent less than 50% of the outstanding voting securities of the merged or acquiring company, or (iii) to sell or otherwise transfer all or substantially all of its assets to any Person, other than an Excluded Person, then, and in each such case, the agreement governing such transaction shall make proper provision so that, unless earlier exercised by Grantee, the Option shall, upon the consummation of any such transaction and upon the tenns and conditions set forth herein, be converted into, or exchan�ed for, an option with identical ternis appropriately adjusted to acquire the number and class of shares or other securities or property that Grantee would have received in respect of Issuer Common Stock if the Option had been exercised immediately prior to such consolidation, 0037c;;-OGC7-^u23's°-9?cF'rJJy-?G?. 10 merger, sale, or transfer; or the record date therefor, as applicable and make any other necessary adjustments; �rovided, however, that if such a conversion or exchange cannot, because of applicable Law be the same as the Option, such terms shall be as similar as possible and in no event less advantageous to Grantee than the Option. (b) In addition to any other restrictions or covenants, Issuer agrees that it shall not enter or agree to enter into any transaction described in Section 5.2(a) unless the Acquiring Corporation (as hereinafter defined) and any Person that controls the Acquiring Corporation assume in writing all the obligations of Issuer hereunder and agree for the benefit of Grantee to comply with this Article V. (c) For purposes of this Section 5.2, the term "Acquirin� Cor�oration" shall mean (i) the continuing or surviving Person of a consolidation or merger with Issuer (if other than Issuer), (ii) Issuer in a consolidation or merger in which Issuer is the continuing or surviving or acquiring Person, and (iii) the transferee of all or substantially all of Issuer's assets. ARTICLE VI MISCELLANEOUS 6.1 Total Profit. (a) Not�vithstanding any other provision of this Agreement, in no event shall Grantee's Total Profit (as hereinafter defined) plus any Time Wamer Termination Fee paid pursuant to Section 8.2(b) and any fees paid by Issuer pursuant to Section 8.2(d) of the Merger Agreement (such Time Warner Termination Fee and such fees paid pursuant to Section 82(d) of the Merger A�reement, collectively, the "Total Issuer Fees") exceed in the aggregate an amount (the "Limitation Amount") equal to 2.75% of the product of (x) the number of shares of Issuer Common Stock outstanding as of the date hereof (assuming the exercise of all outstanding options (other than the Option) and the conversion into Issuer Common Stock of all securities of the Issuer convertible into Issuer Common Stock) multiplied by (y) the Exchange Ratio multiplied by (z) the last sale price of the common stock, par value $0.01 per share, of Grantee on the NYSE on January 7, 2000, and, if the total amount that would otherwise be received by Grantee othen�vise would exceed such amount, Grantee, at its sole election, shall either (i) reduce the number of shares of Issuer Common Stock subject to this Option, (ii) deliver to Issuer for cancellation Option Shares previously purchased by Grantee, (iii) reduce the amount of the Option Repurchase Price or the Option Share Repurchase Price, (iv) pay cash to Issuer, or (v) any combination thereof, so that Grantee's actually realized Total Profit, when aggregated with the Total Issuer Fees so paid to Grantee, shall not exceed the Limitation Amount after taking into account the fore�oing actions. (b) Notwithstanding any other provision of this Agreement, the Option may not be exercised for a number of Option Shares as would, as of the date of exercise, result in a Notional Total Profit (as defined below) which, together with the Total Issuer Fees theretofore' .,.,. �„-„��,-�za�9-�9s=a�J4-�ca 11 paid to Grantee, would exceed the Limitation Amount; �rovided, that nothing in this sentence shall restrict any exercise of the Option permitted hereby on any subsequent date. (c) As used herein, the term "Total Profit" shall mean the aggregate amount (before taxes) of the following: (i) the amount received by Grantee pursuant to Issuer's repurchase of the Option (or any portion thereo fl pursuant to Section 5.1, (ii) (x) the amount received by Grantee pursuant to Issuer's repurchase of Option Shares pursuant to Section 5. l, less (y) Grantee's purchase price for such Option Shares, (iii) (x) the net cash amounts or the fair market value of any property received by Grantee pursuant to any consummated ann's-length sales of Option Shares (or any other securities into which such Option Shares are converted or exchanged) to any unaffiliated party, less (y) Grantee's purchase price of such Option Shares. (d) As used herein, the term "Notional Total Profit" with respect to any number of Option Shares as to which Grantee may propose to exercise the Option shall be the Total Profit determined as of the date of such proposal assuming that the Option was exercised on such date for such number of Option Shares and assuming that such Option Shares, together with all other Option Shares held by Grantee and its affiliates as of such date, were sold for cash at the closing market price (less customary brokerage commissions) for shares of Issuer Common Stock on the preceding trading day on the NYSE (or on any other nationally recognized exchange or trading system on which shares of Issuer Common Stock are then so listed or traded). 6.2 Further Assurances: Listin�. (a) From time to time, at the other party's request and without further consideration, each party hereto shall execute and deliver such additional documents and take all such further action as may be necessary or desirable to consummate the transactions contemplated by this Agreement, including, without limitation, to vest in Grantee good and marketable title, free and clear of all Liens, to any Option Shares purchased hereunder. Issuer agrees not to avoid or seek to avoid (whether by charter amendment or through reorganization, consolidation, merger, issuance of rights or securities, the Time Warner Rights Agreement or similar agreement, dissolution or sale of assets, or by any other voluntary act) the observance or performance of any of the covenants, agreements or conditions to be observed or performed hereunder by it. (b) If the Issuer Common Stock or any other securities to be acquired upon exercise of the Option are then listed on the NYSE (or any other national securities exchange or trading system), Issuer, upon the request of Grantee, will promptly file an application to list the shares of Issuer Common Stock or such other securities to be acquired upon exercise of the Option on the NYSE (and any other national securities exchange or trading ' system) and will use reasonable best efforts to obtain approval of such listing as promptly as practicable. 6.3 Division of O�tion; Lost O�tions. The Agreement (and the Option granted hereby) are exchangeable, without expense, at the option of Grantee, upon presentation and ��3 ;:..,-„c�--��s:�-a��-,�.;;-„c� 12 surrender of this Agreement at the principal office of Issuer, for other agreements providing for Options of different denominations entitling Grantee to purchase, on the same terms and subject to the same conditions as are set forth herein, in the aggregate the same number of Option Shares purchasable hereunder. Upon receipt by Issuer of evidence reasonably satisfactory to it of the loss, theft or destruction or mutilation of this Agreement, and (in the case of loss, theft or destruction) of reasonably satisfactory indemnification, and upon surrender and cancellation of this Agreement, if mutilated, Issuer will execute and deliver a new agreement of like tenor and date. 6.4 Amendment. This Agreement may not be amended except by an instrument in writing signed on behalf of each of the parties hereto. 6.5 Notices. All notices and other communications hereunder shall be in writing and shall be deemed duly g-iven (a) on the date of delivery if delivered personally, or by telecopy or telefacsimile, upon confirmation of receipt, (b) on the first Business Day following the date of dispatch if delivered by a recogniaed next-day courier service, or (c) on the tenth Business Day following the date of mailing if delivered by registered or certified mail, return receipt requested, postage prepaid. All notices hereunder shall be delivered as set forth below, or pursuant to such other instructions as may be designated in writing by the party to receive such notice: (a) if to Grantee to: America Online, Inc. 22000 AOL Way Dulles, Virginia Fax: (703) 265-1495 Attention: Paul T. Cappuccio, Esq. with a copy to: Simpson Thacher & Bartlett 425 Lexington Avenue I�Tew York, New York 10017 Fax: (212) 455-2502 Attention: Richard I. Beattie, Esq. (b) if to Issuer to: Time Wamer Inc. 75 Rockefeller Plaza Ne«� York, iv`Y 10019 Fax: (212) 265-2646 Attention: Christopher P. Bogart, Esq. G:�'o.-GCui-G2c39-9°Hr'?JJ4-P.G?, 13 with a copy to: Cravath, Swaine & Moore Worldwide Plaza 825 Eighth Avenue New York, New York 10019 Fax: (212) 474-3700 Attention: Robert A. Kindler, Esq. 6.6 Interpretation. When a reference is made in this Agreement to Articles, Sections, Exhibits or Schedules, such reference shall be to an Article or Section of or Exhibit or Schedule to this Agreement unless otherwise indicated. The headings contained in this Agreement are for reference puiposes only and shall not affect in any way the meaning or interpretation of this Agreement. Whenever the words "include," "includes" or "including" are used in this Agreement, they shall be deemed to be followed by the words `�vithout limitation." 6.7 Counterparts. This Agreement may be executed in one or more counterparts, all of which shall be considered one and the same agreement and shall become effective when one or more counterparts have been signed by each of the parties and delivered to the other party, it being understood that both parties need not sign the same counterpart. 6.8 Entire Agreement: No Third Party Beneficiaries. (a) This Agreement and the other agreements of the parties referred to herein constitute the entire agreement and supersede all prior agreements and understandings, both written and oral, among the parties with respect to the subject matter hereof. (b) This Agreement shall be binding upon and inure solely to the benefit of each party hereto, and nothing in this Agreement, express or implied, is intended to or shall confer upon any other Person any right, benefit or remedy of any nature whatsoever under or by reason of this Agreement. 6.9 Governin�, Law. This Agreement shall be governed and construed in accordance with the laws of the State of Delaware (without giving effect to choice of law principles thereo�. 6.10 Severabilitx. If any term or other provision of this Agreement is invalid, ille;al or incapable of being enforced by any law or public policy, all other terms and provisions of this Agreement shall nevertheless remain in full force and effect so long as the economic or le�al substance of the transactions contemplated hereby is not affected in any manner materially adverse to any party. Upon such determination that any term or other provision is invalid, illegal or incapable of being enforced, the parties hereto shall negotiate in good faith to modify this A�,�-eement so as to effect the original intent of the parties as closely as possible in an acceptable manner in order that the transactions contemplated hereby are consummated as originally contemplated to the � eatest extent possible. ,,,� , :..,-_„�--v_o�?-993c?D.;4-nGR 14 6.11 Assignment. Neither this Agreement nor any of the rights, interests or obligations hereunder shall be assigned by any of the parties hereto, in whole or in part (whether by operation of law or otherwise), without the prior written consent of the other party, and any attempt to make any such assignment without such consent shall be null and void. Subject to the preceding sentence, this Agreement will be binding upon, inure to the benefit of and be enforceable by the parties and their respective successors and assigns. 6.12 Submission to Jurisdiction: Waivers. Each of Grantee and Issuer irrevocably agrees that any legal action or proceeding with respect to this Agreement or for recognition and enforcement of any judgment in respect hereof brought by the other party hereto or its successors or assigns may be brought and determined in the Chancery or other Courts of the State of Delaware, and each of Grantee and Issuer hereby irrevocably submits with regard to any such action or proceeding for itself and in respect to its property, generally and unconditionally, to the nonexclusive jurisdiction of the aforesaid courts. Each of Grantee and Issuer hereby inevocably waives, and agrees not to assert, by way of motion, as a defense, counterclaim or otherwise, in any action or proceeding with respect to this Agreement, (a) any claim that it is not personally subject to the jurisdiction of the above-named courts for any reason other than the failure to lawfully serve process (b) that it or its property is exempt or immune from jurisdiction of any such court or from any legal process commenced in such courts (whether through service of notice, attachment prior to judgment, attachment in aid of execution of judgment, execution of judgment or otherwise), (c) to the fullest extent permitted by applicable law, that (i) the suit, action or proceeding in any such court is brought in an inconvenient forum, (ii) the venue of such suit, action or proceeding is improper and (iii) this Agreement, or the subject matter hereof, may not be enforced in or by such courts and (d) any right to a trial by jury. 6.13 Enforcement. The parties agree that irreparable damage would occur in the event that any of the provisions of this Agreement were not performed in accordance with their specific terms. It is accordingly agreed that the parties shall be entitled to specific. performance of the terms hereof, this being in addition to any other remedy to which they are entitled at law or in equity. 6.14 Failure or Indulgence Not Waiver: Remedies Cumulative. No failure or delay on the part of any party hereto in the exercise of any right hereunder will impair such right or be construed to be a waiver of, or acquiescence in, any breach of any representation, warranty or agreement herein, nor will any single or partial exercise of any such right preclude other or further exercise thereof or of any other right. All rights and remedies existing under this Agreement are cumulative to, and not exclusive to, and not exclusive of, any rights or remedies othen�rise available. [Remainder of this page intentionally left blank] ,,,_ .,�-��..�-��"0�9-093F?D�4-hGR IN WITNESS WHEREOF, Grantee and Issuer have caused this Agreement to be duly executed as of the date first above written. AMERICA ONLIN C. By: Nam . tephen M. Case Title: Chairman & Chief Executive Officer TIME WARNER INC. By: Name: Title: IV 1`�IT?�ESS «�'HEREO�, Grantee and Is�ue: ha�•e caused this A�eeme:�t to be dul�� e�ecuted as of� the date fir�t above «rrir[c~n, .��ERTC:�. ai� LI� E. Il�C, By: Name: Title: T1v1E �t'.�R`ER NC. g�.. �.k • � � ta�e: Titic: EXECUTION COPY STOCK OPTION AGREEMENT, dated as of January 10, 2000 (the "Aoreement"), between Time Warner Inc., a Delaware corporation ("Grantee"), and America Online, Inc., a Delaware corporation ("Issuer"). WITNESSETH: WHEREAS, Grantee and Issuer are, concurrently with the execution and delivery of this Agreement, entering into an Agreement and Plan of Merger, dated as of the date hereof (the "Mereer Aereement;" capitalized terms used without definition herein having the meanings assigned to them in the Merger Agreement), pursuant to which the parties will engage in a business combination in a merger of equals (the "MerQer"); and WHEREAS, as a condition to their willingness to enter into the Merger Agreement, Grantee has required that Issuer agree, and believing it to be in the best interests of Issuer, Issuer has agreed, among other things, to grant to Grantee the Option (as hereinafter defined) to purchase shares of common stock, par value S.O1 per share, of Issuer ("Issuer Common Stock") at a price per share equal to the Exercise Price (as hereinafter defined). NOW THEREFORE, in consideration of the foregoing and the mutual representations, warranties, covenants and agreements herein contained, and intending to be legally bound hereby, the parties hereto a�ee as follows: ARTICLE I OPTION TO PURCHASE SHARES 1.1 Grant of O tn ion. (a) Issuer hereby grants to Grantee an irrevocable option to purchase, in whole or in part, an aggregate of up to 452,535,148 duly authorized, validly issued, fully paid and nonassessable shares of Issuer Common Stock (representing 19.9% of the outstanding shares of Issuer Common Stock as of January 5, 2000) on the terms and subject to the conditions set forth herein (the " ti n"); rovide , wever, that in no event shall the number of shares of Issuer Common Stock for which this Option is exercisable exceed 19.9% of the issued and outstanding shares of Issuer Common Stock at the time of exercise without giving effect to the issuance of any Option Shares (as hereinafter defined). The number of shares of Issuer Common Stock that may be received upon the exercise of the Option and the Exercise Price are subject to adjustment as herein set forth. (b) In the event that any additional shares of Issuer Common Stock are issued or othen�-ise become outstanding after the date of this A�reement (other than pursuant to this Agreement and other than pursuant to an event described in Section 3.1 hereo�, the number of shares of Issuer Common Stock subject to the Option shall be increased so that, after such ��%..� -..�.. , -v2259-AC1:,521M-;,GR � issuance, such number together with any shares of Issuer Common Stock previously issued pursuant hereto, equals 19.9% of the number of shares of Issuer Common Stock then issued and outstanding without giving effect to any shares subject or issued pursuant to the Option. Nothing contained in this Section 1.1(b) or elsewhere in this Agreement shall be deemed to authorize Issuer to breach or fail to comply with any provision of the Merger Agreement. As used herein, the term "Option Shares" means the shares of Issuer Common Stock issuable pursuant to the Option, as the number of such shares shall be adjusted pursuant to the terms hereof. 1.2 Exercise of O�tion. (a) The Option may be exercised by Grantee, in whole or in part, at any time; or from time to time, commencing upon the Exercise Date and prior to the Expiration Date. As used herein, the term "Exercise Date" means the date on which Grantee becomes unconditionally entitled to receive the America Online Termination Fee pursuant to Section 8.2(c) of the Merger Agreement. As used herein, the term "Expiration Date" means the first to occur prior to Grantee's exercise of the Option pursuant to Section 1.2(b) of: Issuer; (i) the Effective Time; (ii) written notice of termination of this Agreement by Grantee to (iii) 12 months after the first occurrence of an Exercise Date; or (iv) the date of termination of the Merger Agreement, unless, in the case of this clause (iv), Grantee has the right to receive the America Online Termination Fee either (x) upon or (y) following such termination upon the occurrence of certain events, in which case the Option will not terminate until the later of (x) 15 business days following the time the America Online Termination Fee becomes unconditionally payable and (y) the expiration of the period in which Grantee has such right to receive the America Online Termination Fee. Notwithstanding the termination of the Option, Grantee shall be entitled to purchase those Option Shares ��ith respect to which it may have exercised the Option by delivery of an Option Notice (as defined below) prior to the Expiration Date, and the termination of the Option will not affect any rights hereunder which by their terms do not terminate or expire prior to or at the Expiration Date. (b) In the event Grantee wishes to exercise the Option, Grantee shall send a�vritten notice to Issuer of its intention to so exercise the Option (an "Ontion Notice"), specifying the number of Option Shares to be purchased (and the denominations of the certificates, if more than one), �vhether the aggregate Exercise Price will be paid in cash or by surrenderin� a portion of the Option in accordance �vith Section 1.3(b) or a combination thereof, and the place in the linited States, time and date of the closing of such purchase (the "O_ption Closina" and the date of such Closing, the "�tion Closin� Date"), which date shall not be less .�37c„-�.,. �-_2�59-AviA52'�..-AGR 3 than two Business Days nor more than ten Business Days from the date on which an Option Notice is delivered; rop vided that the Option Closing shall be held only if (i) such purchase would not otherwise violate or cause the violation of, any applicable material law, statute, ordinance, rule or regulation (collectively, "Laws") (including the HSR Act and the Communications Act), and (ii) no material judgment, order, writ, injunction, ruling or decree of any Governmental Entity (collectively, "Or er ") shall have been promulgated, enacted, entered into, or enforced by any Govemmental Entity which prohibits delivery of the Option Shares, whether temporary, preliminary or permanent; �rovided, however, that the parties hereto shall use their reasonable best efforts to (x) promptly make and process all necessary filings and applications and obtain all consents, approvals, Orders, authorizations, registrations and declarations or expiration or termination of any required waiting periods (collectively, "Aonro��als") and to comply with any such applicable Laws and (y) have any such Order vacated or reversed. In the event the Option Closing is delayed pursuant to clause (i) or (ii) above, the Option Closing shall be within ten Business Days following the cessation of such restriction, violation, Law or Order or the receipt of any necessary Approval, as the case may be (so long as the Option Notice was delivered prior to the Expiration Date); provided further that, not�vithstanding any prior Option Notice, Grantee shall be entitled to rescind such Option Notice and shall not be obligated to purchase any Option Shares in connection with such exercise upon written notice to such effect to Issuer. (c) At any Option Closing, (i) Issuer shall deliver to Grantee all of the Option Shares to be purchased by delivery of a certificate or certificates evidencing such Option Shares in the denominations designated by Grantee in the Option Notice, and (ii) if the Option is exercised in part and/or surrendered in part to pay the aggregate Exercise Price pursuant to Section 1.3(b), Issuer and Grantee shall execute and deliver an amendment to this Agreement reflecting the Option Shares for which the Option has not been exercised and/or surrendered. If at the time of issuance of any Option Shares pursuant to an exercise of all or part of the Option hereunder, Issuer shall have issued any rights or other securities which are attached to or otherwise associated with the Issuer Common Stock, then each Option Share issued pursuant to such exercise shall also represent such rights or other securities with terms substantially the same as and at least as favorable to Grantee as are provided under any shareholder rights agreement or similar agreement of Issuer then in effect. At the Option Closing, Grantee shall pay to Issuer by wire transfer of immediately available funds to an account specified by Issuer to Grantee in �vriting at least two Business Days prior to the Option Closing an amount equal to the Exercise Price multiplied by the number of Option Shares to be purchased for cash pursuant to this Article I; �rovided that the failure or refusal of Issuer to specify an account shall not affect Issuer's obligation to issue the Option Shares. (d) Upon the delivery by Grantee to Issuer of the Option Notice and the tender of the applicable aggregate Exercise Price in immediately available funds or the requisite portion of the Option in accordance with Section 1.3, Grantee shall be deemed to be the holder of record of the Option Shares issuable upon such exercise, notwithstanding that the stock transfer books of Issuer may then be closed, that ceRificates representing such Option Shares may not then ha��e been actually delivered to Grantee, or Issuer may have failed or refused to take any action required of it hereunder. Issuer shall pay all expenses that may be payable in ' CG37��-OCJ;-02269-i3O'_:,52::^.-„G� 4 connection with the preparation, issuance and delivery of stock certificates or an amendment to this Agreement under this Section 1.2 and any filing fees and other expenses arising from the perfonnance of the transactions contemplated hereby. 1.3 Pavments. (a) The purchase and sale of the Option Shares pursuant to Section 1.2 of this Agreement shall be at a purchase price equal to $73.75 per Share (as such amount may be adjusted pursuant to the terms hereof, the "Exercise Price"), payable at Grantee's option in cash, by surrender of a portion of the Option in accordance with Section 1.3(b), or a combination thereof. (b) Grantee may elect to purchase Option Shares issuable, and pay some or all of the aggregate Exercise Price payable, upon an exercise of the Option by sunendering a portion of the Option with respect to such number of Option Shares as is determined by dividing (i) the aggregate Exercise Price payable in respect of the number of Option Shares being purchased in such manner by (ii) the excess of the Fair Market Value (as defined belo�v) per share of Issuer Common Stock as of the last trading day preceding the date Grantee delivers its Option Notice (such date, the "Option Exercise Date") over the per share Exercise Price. The "Fair Market Value" per share of Issuer Common Stock shall be (i) if the Issuer Common Stock is listed on the New York Stock Exchange, Inc. (the "NYSE") or any other nationally recognized exchange or trading system as of the Option Exercise Date, the average of last reported sale prices per share of Issuer Common Stock thereon for the 10 trading days commencing on the 12`h trading day immediately preceding the Option Exercise Date, or (ii) if the Issuer Common Stock is not listed on the NYSE or any other nationally recognized exchange or trading system as of the Option Exercise Date, the amount determined by a mutually acceptable independent investment banking firm as the value per share the Issuer Common Stock would have if publicly traded on a nationally recognized exchange or trading system (assuming no discount for minority interest, illiquidity or restrictions on transfer). That portion of the Option so surrendered under this Section 1.3(b) shall be canceled and shall thereafter be of no further force and effect. (c) Certificates for the Option Shares delivered at an Option Closing will have typed or printed thereon a restrictive legend which will read substantially as follows: "THE SECURITIES REPRESENTED BY THIS CERTIFICATE HAVE NOT BEEN REGISTERED UNDER THE SECURITIES ACT OF 1933, AS AMENDED, AND MAY BE REOFFERED OR SOLD ONLY IF SO REGISTERED OR IF AN EXEMPTION FROM SUCH REGISTR.ATION IS AVAILABLE. SUCH SECURITIES ARE ALSO SUBJECT TO ADDITIONAL RESTRICTIONS ON TRANSFER AS SET FORTH IN THE STOCK OPTION AGREEMENT DATED AS OF JANJARY 10, 2000. A COPY OF WHICH MAY BE OBTAINED FROM THE SECRETARY OF AMERICA ONLI?�TE, INC. AT ITS PRIi�'CIPAL EXECUTIVE OFFICES." OC3�20-,,.,� i-��2E9-AO'_i,52'----AG� 5 It is understood and agreed that (i) the reference to restrictions arising under the Securities Act in the above legend will be removed by delivery of substitute certificate(s) without such reference if such Option Shares have been registered pursuant to the Securities Act, such Option Shares have been sold in reliance on and in accordance with Rule 144 under the Securities Act or Grantee has delivered to Issuer a copy of a letter from the staff of the SEC, or an opinion of counsel in form and substance reasonably satisfactory to Issuer and its counsel, to the effect that such legend is not required for purposes of the Securities Act and (ii) the reference to restrictions purs�.�ant to this Agreement in the above legend will be removed by delivery of substitute certificate(s) without such reference if the Option Shares evidenced by certificate(s) containing such reference have been sold or transferred in compliance with the provisions of this Agreement under circumstances that do not require the retention of such reference. ARTICLE II REPRESENTATIONS AND WARRANTIES 2.1 Representations and Warranties of Grantee. Grantee hereby represents and warrants to Issuer that any Option Shares or other securities acquired by Grantee upon exercise of the Option will not be taken with a view to the public distribution thereof and will not be transferred or otherwise disposed of except in a transaction registered or exempt from registration under the Securities Act. 2.2 Re�resentations and Warranties of Issuer. Issuer hereby represents and warrants to Grantee as follows: (a) Option Share�. Issuer has taken all necessary corporate and other action to authorize and reserve for issuance, and, subject to receipt of any Approvals, to pennit it to issue, the Option Shares and all additional shares or other securities which may be issued pursuant to Section 3.1 upon exercise of the Option, and, at all times from the date hereof until such time as the obligation to deliver Option Shares hereunder terminates, will have reserved for issuance upon exercise of the Option the Option Shares and such other additional shares or securities, if any. All of the Option Shares and all additional shares or other securities or property �vhich may be issuable pursuant to Section 3. l, upon exercise of the Option and issuance pursuant hereto, shall be duly authorized, validly issued, fully paid and nonassessable, shall be delivered free and clear of all Liens of any nature whatsoever, and shall not be subject to any preemptive or similar right of any Person. (b) No Restrictions. No Delaware law or other takeover statute or similar Law and no provision of the Restated Certificate of Incorporation or Bylaws of Issuer or any agreement to which Issuer is a party (a) would or would purport to impose re�trictions which might ad��ersely affect or delay the consummation of the transactions contemplated by this Agc-eement, or (b) as a result of the consummation of the transactions contemplated by this A�reement, (i) �vould or ��-ould purport to restrict or impair the ability of Grantee to vote or otherwise exercise the rights of a shareholder with respect to securities of Issuer or any of its _,,.%c0-CC�7-C2269-AO1n52!?%-nGR � Subsidiaries that may be acquired or controlled by Grantee or (ii) would or would purport to entitle any Person to acquire securities of Issuer. ARTICLE III ADJUSTMENT UPON CHANGES IN CAPITALIZATION 3.1 Adjustment Upon Changes in Capitalization. In addition to the adjustment in the number of shares of Issuer Common Stock that may be purchased upon exercise of the Option pursuant to Section 1. I of this Agreement, the number of shares of Issuer Common Stock that may be purchased upon the exercise of the Option and the Exercise Price shall be subject to adjustment from time to time as provided in this Section 3.1. In the event of any change in the number of issued and outstanding shares of Issuer Common Stock by reason of any stock dividend, split-up, merger, recapitalization, combination, conversion, exchange of shares, spin- off or other change in the corporate or capital structure of Issuer which would have the effect of diluting or otherwise diminishing Grantee's rights hereunder, the number and kind of Option Shares or other securities subject to the Option and the Exercise Price therefor shall be appropriately adjusted so that Grantee shall receive upon exercise of the Option (or, if such a change occurs between exercise and the Option Closing, upon the Option Closing) the number and kind of shares or other securities or property that Grantee would have received in respect of the Option Shares that Grantee is entitled to purchase upon exercise of the Option if the Option had been exercised (or the purchase thereunder had been consummated, as the case may be) immediately prior to such event or the record date for such event, as applicable. The rights of Grantee under this Section shall be in addition to, and shall in no way limit, its rights against Issuer for breach of or the failure to perform any provision of the Merger Agreement. ARTICLE IV REGISTRATION RIGHTS 4.1 Registration of Option Shares Under the Securities Act. (a) If requested by Grantee at any time and from time to time within two years after receipt by Grantee of Option Shares (the "Registration Period"), Issuer shall use its reasonable best efforts, as promptly as practicable, to effect the registration under the Securities Act and any applicable state law (a "Demand Registration") of such number of Option Shares or such other Issuer securities otivned by or issuable to Grantee in accordance with the method of sale or other disposition contemplated by Grantee, including a"shelf' registration statement under Rule 415 of the Securities Act or any successor provision, and ta obtain all consents or �vai��ers of other parties that are required therefor. Grantee agrees to use reasonable best efforts to cause, and to use reasonable best efforts to cause any underwriters of any sale or other disposition to cause, any sale or other disposition pursuant to such registration statement to be effected on a widely distributed basis so that upon consummation thereof no purchaser or ��_,��-��--�zz�a-;,oi:,s��:�-�c� � transferee will own beneficially more than 3% of the then-outstanding voting power of Issuer. Except with respect to such a"shelf' registration, Issuer shall keep such Demand Registration effective for a period of not less than 150 days, unless, in the written opinion of counsel to Issuer, which opinion shall be delivered to Grantee and which shall be satisfactory in form and substance to Grantee and its counsel, such registration under the Securities Act is not required in order to lawfully sell and distribute such Option Shares or other Issuer securities in the manner contemplated by Grantee. Issuer sha�l only have the obligation to effect three Demand Registrations pursuant to this Section 4.1; rovi ed that only requests relating to a registration statement that has become effective under the Securities Act shall be counted for purposes of determining the number of Demand Registrations made. Issuer shall be entitled to postpone for up to 150 days from receipt of Grantee's request for a Demand Registration the filing of any registration statement in connection therewith if the Board of Directors of Issuer determines in its good faith reasonable judgment that such registration would materially interfere with or require premature disclosure of, any material acquisition, reorganization, pending or proposed offering of Issuer Securities or other transaction involving Issuer or any other material contract under active negotiation by Issuer; and �rovided further that Issuer shall not have postponed any Demand Registration pursuant to this sentence during the twelve month period immediately preceding the date of delivery of Grantee's request for a Demand Registration. (b) If Issuer effects a registration under the Securities Act of Issuer Common Stock for its own account or for any other stockholders of Issuer (other than on Form S-4 or Form S-8, or any successor form), Grantee shall have the right to participate in such registration and include in such registration the number of shares of Issuer Common Stock or such other Issuer securities as Grantee shall designate by notice to Issuer (an " id ntal Re�istration" and, together with a Demand Registration, a"Registration"); ron vided, however, that, if the managing underwriters of such offering advise Issuer in writing that in their opinion the number of shares of Issuer Common Stock or other securities requested to be included in such Incidental Registration exceeds the number which can be sold in such offering, Issuer shall include therein (i) first, all shares proposed to be included therein by Issuer, (ii) second, subject to the rights of any other holders of registration rights in effect as of the date hereof, the shares requested to be included therein by Grantee and (iii) third, shares proposed to be included therein by any other stockholder of Issuer. Participation by Grantee in any Incidental Registration shall not affect the obligation of Issuer to effect Demand Registrations under this Section 4.1. Issuer may withdraw any registration under the Securities Act that gives rise to an Incidental Registration without the consent of Grantee. (c) In connection with any Registration pursuant to this Section 4.1, (i) Issuer and Grantee shall provide each other and any underwriter of the offering with customary representations, warranties, covenants, indemnification and contribution obligations in connection with such Registration, and (ii) Issuer shall use reasonable best efforts to cause any Option Shares included in such Registration to be approved for listing on the NYSE or any other nationally reco�nized exchange or trading system upon which Issuer's securities are then listed, subject to official notice of issuance, ��hich notice shall be given by Issuer upon issuance. Grantee ��ill provide all infonnation reasonably requested by Issuer for inclusion in any registration statement to be filed hereunder. The costs and expenses incurred by Issuer in �G37c��-�^v��7-��22o9-nOli,521r?—AGR 0 connection with any Registration pursuant to this Section 4.1 (including any fees related to qualifications under Blue Sky Laws and SEC filing fees) (the "Registration Expenses") shall be bome by Issuer, excluding legal fees of Grantee's counsel and underwriting discounts or commissions with respect to Option Shares to be sold by Grantee included in a Registration. 4.2 Transfers of Option Shares. The Option Shares may not be sold, assigned, transferred, or otherwise disposed of except (i) in an underwritten public offering as provided in section 4.1 or (ii) to any purchaser of transferee who would not, to the knowledge of the Grantee after reasonable inquiry, immediately following such sale, assignment, transfer or disposal beneficially own more than 3% of the then-outstanding voting power of the Issuer; �rovided, however, that Grantee shall be permitted to sell any Option Shares if such sale is made pursuant to a tender or exchange offer that has been approved or recommended by a majority of the members of the Board of Directors of Issuer (which majority shall include a majority of directors who were directors as of the date hereo fl. ARTICLE V REPURCHASE RIGHTS; SUBSTITUTE OPTIONS 5.1 Repurchase Ri�hts. (a) Subject to Section 6.1, at any time on or after the Exercise Date and prior to the Expiration Date, Grantee shall have the right (the "Re�urchase Right") to require Issuer to repurchase from Grantee (i) the Option or any part thereof as Grantee shall designate at a price (the "Option Repurchase Price") equal to the amount, subject to reduction at the sole discretion of Grantee pursuant to clause (iii) bf Section 6.1(a), by which (A) the MarkedOffer Price (as defined below) exceeds (B) the Exercise Price, multiplied by the number of Option Shares as to which the Option is to be repurchased and (ii) such number of Option Shares as Grantee shall designate at a price (the "Option Share Ret�urchase Price") equal to the Market/Offer Price multiplied by the number of Option Shares so designated. The term "Market/Offer Price" shall mean the highest of (i) the highest price per share of Issuer Common Stock offered or paid in any Acquisition Proposal, or (ii) the highest closing price for shares of Issuer Common Stock during the six-month period immediately preceding the date Grantee gives the Repurchase Notice (as hereinafter defined). In determining the Market/Offer Price, the value of consideration other than cash shall be determined by a nationally recognized investment banking firm selected by Grantee and reasonably acceptable to Issuer, which determination, absent manifest error, shall be conclusive for all purposes of this Agreement. (b) Grantee shall exercise its Repurchase Right by delivering to Issuer «�ritten notice (a "Re�urchase Notice") stating that Grantee elects to require Issuer to repurchase all or a portion of the Option and/or the Option Shares as specified therein. The closing of the Repurchase Right (the "Re�urchase Closing") shall take place in the United States at the place, time and date specilied in the Repurchase Notice, �vhich date shall not be less than two Business Davs nor more than ten Business Days from the date on which the Repurchase Notice is C0: �...,-��7-C225�-�,�_n.2i'.'Q-i.GR � delivered. At the Repurchase Closing, subject to the receipt of a writing evidencing the surrender of the Option and/or certificates representing Option Shares, as the case may be, Issuer shall deliver to Grantee the Option Repurchase Price therefor or the Option Share Repurchase Price therefor, as the case may be, or the portion thereof that Issuer is not then prohibited under applicable Law from so delivering. At the Repurchase Closing, (i) Issuer shall pay to Grantee the Option Repurchase Price for the portion of the Option which is to be repurchased or the Option Shares Repurchase Price for the number of Option Shares to be repurchased, as the case may be, by wire transfer of immediately available funds to an account specified by Grantee at least 24 hours prior to the Repurchase Closing and (ii) if the Option is repurchased only in part, Issuer and Grantee shall execute and deliver an amendment to this Agreement reflecting the Option Shares for which the Option is not being repurchased. (c) To the extent that Issuer is prohibited under applicable Law from repurchasing the portion of the Option or the Option Shares designated in such Repurchase Notice, Issuer shall immediately so notify Grantee and thereafter deliver, from time to time, to Grantee the portion of the Option Repurchase Price and the Option Share Repurchase Price, respectively, that it is no longer prohibited from delivering, within five Business Days after the date on �vhich Issuer is no longer so prohibited; provided, however, that if Issuer at any time after delivery of a Repurchase Notice is prohibited under applicable Law from delivering to Grantee the full amount of the Option Repurchase Price and the Option Share Repurchase Price for the Option or Option Shares to be repurchased, respectively, Grantee may rescind the exercise of the Repurchase Right, whether in whole, in part or to the extent of the prohibition, and, to the extent rescinded, no part of the amounts, terms or the rights with respect to the Option or Repurchase Right shall be changed or affected as if such Repurchase Right were not exercised.. Issuer shall use its reasonable best efforts to obtain all required regulatory and legal approvals and to file any required notices to permit Grantee to exercise its Repurchase Right and shall use its reasonable best efforts to avoid or cause to be rescinded or rendered inapplicable any prohibition on Issuer's repurchase of the Option or the Option Shares. 5.2 Substitute Option. (a) In the event that Issuer enters into an agreement (i) to consolidate ��ith or merge into any Person, other than Grantee or any Subsidiary of Grantee (each an "Excluded Person"), and Issuer is not the continuing or surviving corporation of such consolidation or merger, (ii) to permit any Person, other than an Excluded Person, to merge into Issuer and Issuer shall be the continuing or surviving or acquiring corporation, but, in connection with such merger, the then outstanding shares of Issuer Common Stock shall be changed into or exchanged for stock or other securities of any other Person or cash or any other property or the then outstanding shares of Issuer Common Stock shall after such merger represent less than 50% of the outstanding voting securities of the merged or acquiring company, or (iii) to sell or othenvise transfer all or substantially all of its assets to any Person, other than an Excluded Person, then, and in each such case, the agreement governing such transaction shall make proper pro��ision so that, unless earlier exercised by Grantee, the Option shall, upon the consummation of an�,� such transaction and upon the terms and conditions set forth herein, be converted into, or exchanged for, an option with identical terms appropriately adjusted to acquire the number and .��s�-.,�;,,-o�za9-hc�:,s='_�-��s 10 class of shares or other securities or property that Grantee would have received in respect of Issuer Common Stock if the Option had been exercised immediately prior to such consolidation, merger, sale, or transfer, or the record date therefor, as applicable and make any other necessary adjustments; provided, however, that if such a conversion or exchange cannot, because of applicable Law be the same as the Option, such terms shall be as similar as possible and in no event less advantageous to Grantee than the Option. (b) In addition to any other restrictions or covenants, Issuer agrees that it shall not enter or agree to enter into any transaction described in Section 5.2(a) unless the Acquiring Corporation (as hereinafter defined) and any Person that controls the Acquiring Corporation assume in writing all the obligations of Issuer hereunder and agree for the benefit of Grantee to comply with this Article V. (c) For purposes of this Section 5.2, the term "Acquirin,� Cor�oration" shall mean (i) the continuing or surviving Person of a consolidation or merger with Issuer (if other than Issuer), (ii) Issuer in a consolidation or merger in which Issuer is the continuing or surviving or acquiring Person, and (iii) the transferee of all or substantially all of Issuer's assets. ARTICLE VI MISCELLANEOUS 6.1 Total Profit. (a) Notwithstanding any other provision of this Agreement, in no event shall Grantee's Total Profit (as hereinafter defined) plus any America Online Termination Fee paid pursuant to Section 8.2(c) and any fees paid by Issuer pursuant to Section 8.2(d) of the Merger Agreement (such America Online Termination Fee and such fees paid pursuant to Section 82(d) of the Merger Agreement, collectively, the "Total Issuer Fees") exceed in the aggregate an amount (the "Limitation Amount") equal to 2.75% of the product of (x) the number of shares of Issuer Common Stock outstanding as of the date hereof (assuming the exercise of all outstanding options (other than the Option) and the conversion into Issuer Common Stock of all securities of the Issuer convertible into Issuer Common Stock) multiplied by (y) the last sale price of Issuer Common Stock on the NYSE on January 7, 2000, and, if the total amount that would otherwise be received by Grantee otherwise would exceed such amount, Grantee, at its sole election, shall either (i) reduce the number of shares of Issuer Common Stock subject to this Option, (ii) deliver to Issuer for cancellation Option Shazes previously purchased by Grantee, (iii) reduce the amount of the Option Repurchase Price or the Option Share Repurchase Price, (iv) pay cash to Issuer, or (v) any combination thereof, so that Grantee's actually realized Total Profit, �vhen aggregated with the Total Issuer Fees so paid to Grantee, shall not ex_ceed the Limitation Amount after taking into account the foregoing actions. (b) Not��ithstanding any other provision of this Agreement, the Option may not be exercised for a number of Option Shares as would, as of the date of exercise, result in ,.�.-s�-��c--�zz��-.;�,_as�-_u-:,ct 11 a Notional Total Profit (as defined below) which, together with the Total Issuer Fees theretofore paid to Grantee, would exceed the Limitation Amount; �rovided, that nothing in this sentence shall restrict any exercise of the Option permitted hereby on any subsequent date. (c) As used herein, the term "Totai ProfiY' shall mean the aggregate amount (before taxes) of the following: (i) the amount received by Grantee pursuant to Issuer's repurchase of the Option (or any portion thereo fl pursuant to Section 5.1, (ii) (x) the amount received by Grantee pursuant to Issuer's repurchase of Option Shares pursuant to Section 5. l, less (y) Grantee's purchase price for such Option Shares, (iii) (x) the net cash amounts or the fair market value of any property received by Grantee pursuant to any consummated arm's-length sales of Option Shares (or any other securities into which such Option Shares are converted or exchanged) to any unaffiliated party, less (y) Grantee's purchase price of such Option Shares. (d) As used herein, the term "Notional Total Profit" with respect to any number of Option Shares as to which Grantee may propose to exercise the Option shall be the Total Profit determined as of the date of such proposal assuming that the Option was exercised on such date for such number of Option Shares and assuming that such Option Shares, together with all other Option Shares held by Grantee and its affiliates as of such date, were sold for cash at the closing market price (less customary brokerage commissions) for shares of Issuer Common Stock on the preceding trading day on the NYSE (or on any other nationally recognized exchange or trading system on which shares of Issuer Common Stock are then so listed or traded). 6.2 Further Assurances: Listing. (a) From time to time, at the other party's request and without further consideration, each party hereto shall execute and deliver such additional documents and take all such further action as may be necessary or desirable to consummate the transactions contemplated by this Agreement, including, without limitation, to vest in Grantee good and marketable title, free and clear of all Liens, to any Option Shares purchased hereunder. Issuer agrees not to avoid or seek to avoid (whether by charter amendment or through reorganization, consolidation, merger, issuance of rights or securities, the America Online Rights Agreement or similar agreement, dissolution or sale of assets, or by any other voluntary act) the observance or performance of any of the covenants, agreements or conditions to be observed or performed hereunder by it. (b) If the Issuer Common Stock or any other securities to be acquired upon exercise of the Option are then listed on the NYSE (or any other national securities exchange or trading system), Issuer, upon the request of Grantee, will promptly file an application to list the shares of Issuer Common Stock or such other securities to be acquired upon exercise of the Option on the NYSE (and any other national securities exchange ar trading system) and will use reasonable best efforts to obtain approval of such listing as promptly as practicable. 003?�J-�C07-C22E9-A01�52:N,-AGR 12 6.3 Division of O�tion: Lost O.�tions. The Agreement (and the Option granted hereby) are exchangeable, without expense, at the option of Grantee, upon presentation and surrender of this Agreement at the principal office of Issuer, for other agreements providing for Options of different denominations entitling Grantee to purchase, on the same terms and subject to the same conditions as are set forth herein, in the aggregate the same number of Option Shares purchasable hereunder. Upon receipt by Issuer of evidence reasonably satisfactory to it of the loss, theft or destruction or mutilation of this Agreement, and (in the case of loss, theft or destruction) of reasonably satisfactory indemnification, and upon surrender and cancellation of this Agreement, if mutilated, Issuer will execute and deliver a new agreement of like tenor and date. 6.4 Amendment. This Agreement may not be amended except by an instrument in writing signed on behalf of each of the parties hereto. 6.5 Notices. All notices and other communications hereunder shall be in writing and shall be deemed duly given (a) on the date of delivery if delivered personally, or by telecopy or telefacsimile, upon confirmation of receipt, (b) on the first Business Day following the date of dispatch if delivered by a recognized next-day courier service, or (c) on the tenth Business Day following the date of mailing if delivered by registered or certified mail, return receipt requested, postage prepaid. All notices hereunder shall be delivered as set forth below, or pursuant to such other instructions as may be designated in writing by the party to receive such notice: (a) if to Grantee to: Time Warner Inc. 75 Rockefeller Plaza New York, NY 10019 Fax: (212) 265-2646 Attention: Christopher P. Bogart, Esq. �vith a copy to: Cravath, Swaine & Moore Worldwide Plaza 825 Eighth Avenue New York, New York � 0019 Fax: (212) 474-3700 Attention: Robert A. Kindler, Esq. :�37S0-:C�7-Q2�E4-?.0'_A521N.-hG?. 13 (b) if to Issuer to: America Online, Inc. 22000 AOL Way Dulles, Virginia Fax: (703) 265-1495 Attention: Paul T. Cappuccio, Esq. with a copy to: Simpson Thacher & Bartiett 425 Lexington Avenue New York, New York 10017 Fax: (212) 455-2502 Attention: Richard I. Beattie, Esq. 6.6 Interpretation. When a reference is made in this Agreement to Articles, Sections, Exhibits or Schedules, such reference shall be to an Article or Section of or Exhibit or Schedule to this Agreement unless otherwise indicated. The headings contained in this Agreement are for reference purposes only and shall not affect in any way the meaning or interpretation of this Agreement. Whenever the words "include," "includes" or "including" are used in this Agreement, they shall be deemed to be followed by the words "without limitation." 6.7 Counter�parts. This Agreement may be executed in one or more counterparts, all of which shall be considered one and the same agreement and shall become effective when one or more counterparts have been signed by each of the parties and delivered to the other party, it being understood that both parties need not sign the same counterpart. 6.8 Entire A�reement: No Third Partv Beneficiaries. (a) This Agreement and the other agreements of the parties referred to herein constitute the entire agreement and supersede all prior agreements and understandings, both �vritten and oral, among the parties with respect to the subject matter hereof. (b) This Agreement shall be binding upon and inure solely to the benefit of each party hereto, and nothing in this Agreement, express or implied, is intended to or shall confer upon any other Person any right, benefit or remedy of any nature whatsoever under or by reason of this Agreement. 6.9 Goveming Law. This Agreement shall be governed and censtrued in accordance �vith the la«�s of the State of Delaware (�vithout givinJ effect to choice of law principles thereo�. ��.-s:-,,:;c �-cz�o�-;,c'��szi:.-r�� 14 6.10 Severabilitv. If any term or other provision of this Agreement is invalid, illegal or incapable of being enforced by any law or public policy, all other terms and provisions of this Agreement shall nevertheless remain in full force and effect so long as the economic or legal substance of the transactions contemplated hereby is not affected in any manner materially adverse to any party. Upon such determination that any term or other provision is invalid, illegal or incapable of being enforced, the parties hereto shall negotiate in good faith to modify this Agreement so as to effect the original intent of the parties as closely as possible in an acceptable manner in order that the transactions contemplated hereby are consummated as originally contemplated to the greatest extent possible. 6.11 Assi�nment. Neiiher this Agreement nor any of the rights, interests or obligations hereunder shall be assigned by any of the parties hereto, in whole or in part (whether by operation of law or otherwise), without the prior written consent of the other party, and any attempt to make any such assignment without such consent shall be null and void. Subject to the preceding sentence, this Agreement will be binding upon, inure to the benefit of and be enforceable by the parties and their respective successors and assigns. 6.12 Submission to Jurisdiction; Waivers. Each of Grantee and Issuer irrevocably agrees that any legal action or proceeding with respect to this Agreement or for recognition and enforcement of any judgment in respect hereof brought by the other party hereto or its successors or assigns may be brought and deternzined in the Chancery or other Courts of the State of Delaware, and each of Grantee and Issuer hereby irrevocably submits with regard to any such action or proceeding for itself and in respect to its property, generally and unconditionally, to the nonexclusive jurisdiction of the aforesaid courts. Each of Grantee and Issuer hereby irrevocably waives, and agrees not to assert, by way of motion, as a defense, counterclaim or othenvise, in any action or proceeding with respect to this Agreement, (a) any claim that it is not personally subject to the jurisdiction of the above-named courts for any reason other than the failure to lawfully serve process (b) that it or its property is exempt or immune from jurisdiction of any such court or from any legal process commenced in such courts (whether through service of notice, attachment prior to judgment, attachment in aid of execution of judgment, execution of judgment or otherwise), (c) to the fullest extent permitted by applicable law, that (i) the suit, action or proceeding in any such court is brought in an inconvenient forum, (ii) the venue of such suit, action or proceeding is improper and (iii) this Agreement, or the subject matter hereof, may not be enforced in or by such courts and (d) any right to a trial by jury. 6.13 Enforcement. The parties agree that irreparable damage would occur in the event that any of the provisions of this Agreement were not performed in accordance with their specific terms. It is accordingly agreed that the parties shall be entitled to specific performance of the terms hereof, this being in addition to any other remedy to which they are entitled at law or in equity. 6.14 Failure or Indul�ence Not Waiver; Remedies Cumulative. No failure or delay on the part of any party hereto in the exercise of any right hereunder will impair such right or be construed to be a«�aiver of, or acquiescence in, any breach of any representation, warranty or agreement herein, nor will any single or partial exercise of any such right preclude other or Cv3 io�-OCC7-G22c9-�+C1A521h:-:,GR 15 further exercise thereof or of any other right. All rights and remedies existing under this Agreement are cumulative to, and not exclusive to, and not exclusive of, any rights or remedies othenvise available. [Remainder of this page intentionally left blanic] � _ ,-_„-:,.,� , -C��69-=.CiA52=�:-:,GR IN WITNESS WHEREOF, Grantee and Issuer have caused this Agreement to be duly executed as of the date first above written. AMERICA ONLINE INC. By: e: Stephen M. Case Title: Chairman & Chief Executive Officer TIME WARNER INC. By: 1�Tame: Title: Iv li�"I7v�SS ��iEF�EO�, Grancr.� �3nd Issuer �ave caused this A�eement to be duly execucecl as of the ciatz first above wri�en. .��RIC.� 0�]LI`rE, INC. By: �ane: Titl�: Tr�1E �t'.�.R?�ER I�iC. B y. 'L� � "� � . � r' \ a�e: Tiile: EXECUTION COPY VOTING AGREEMENT, dated as of January 10, 2000 (this "Aereement"), among America Online, Inc., a Delaware corporation ("America Online"), and the stockholders of Time Warner Inc., a Delaware corporation ("Time Warner"), that are parties hereto (each, a "Stockholder" and, collectively, the "Stockholders"). WITNESSETH: WHEREAS, America Online and Time Warner are, concurrently with the execution and delivery of this Agreement, entering into an Agreement and Plan of Merger, dated as of the date hereof (the "Merger A�reement;" capitalized terms used without definition herein having the meanings assigned to them in the Merger Agreement), pursuant to which Time Warner will engage in a business combination in a merger of equals with America Online (the "Time Wamer Merger"); and WHEREAS, as of the date hereof, each Stockholder is the record and beneficial owner of the number of shares of common stock, par value $0.01 per share, of Time Warner ("Time Warner Common Stock"), as set forth on the signature page hereof beneath such Stockholder's name (with respect to each Stockholder, such Stockholder's "Existin, Sg hares" and, together with any shares of Time Warner Common Stock or other voting capital stock of Time Warner acquired after the date hereof, whether upon the exercise of warrants, options, conversion of convertible securities or otherwise, such Stockholder's " hares"); NOW THEREFORE, in consideration of the foregoing and the mutual representations, warranties, covenants and agreements herein contained, and intending to be legally bound hereby, the parties hereto agree as follows: ARTICLE I VOTING 1.1 Agreement to Vote. Each Stockholder hereby agrees that it shall, and shall cause the holder of record on any applicable record date to, from time to time, at the request of America Online, at any meeting (whether annual or special and whether or not an adjourned or postponed meeting) of stockholders of Time Warner, however called, or in connection with any written consent of the holders of Time Warner Common Stock, (a) if a meeting is held, appear at such meeting or otherwise cause the Shares to be coLnted as present thereat for purposes of establishing a quorum, and (b) vote or consent (or cause to be voted or consented), in person or by proxy, all Shares, and any other voting securities of Time Warner (whether acquired heretofore or hereafter) that are beneficially owned or held of record by such Stockholder or as to which such Stockholder has, directly or indirectly, the right to vote or direct the voting, in favor of the approval and adoption of the Merger Agreement, the Time Wamer Merger and any action required in furtherance thereof. 003780-0007-02839-99BG134A-AGR 2 1.2 No Ownershi� Interest. Nothing contained in this Agreement shall be deemed to vest in America Online any direct or indirect ownership or incidence of ownership of or with respect to any Shares. All rights, ownership and economic benefits of and relating to the Shares shall remain vested in and belong to the Stockholders, and America Online shall have no authority to manage, direct, superintend, restrict, regulate, govern, or administer any of the policies or operations of Time Warner or exercise any power or authority to direct the Stockholders in the voting of any of the Shares, except as otherwise provided herein, or in the performance of the Stockholders' duties or responsibilities as stockholders of Time Warner. 1.3 No Inconsistent A.�eements. Each Stockholder hereby covenants and agrees that, except as contemplated by this Agreement and the Merger Agreement, the Stockholder (a) has not entered, and shall not enter at any time while this Agreement remains in effect, into any voting agreement or voting trust with respect to the Shares and (b) has not granted, and shall not grant at any time while this Agreement remains in effect, a proxy or power of attorney with respect to the Shares, in either case, which is inconsistent with such Stockholder's obligations pursuant to this Agreement. ARTICLE II REPRESENTATIONS AND WARRANTIES OF EACH STOCKHOLDER Each Stockholder hereby, severally and not jointly, represents and warrants to America Online as follows: 2.1 Authorization• Validitxof Agreement; Necessarv Action. Such Stockholder has full power and authority to execute and deliver this Agreement, to perform such Stockholder's obligations hereunder and to consummate the transactions contemplated hereby. The execution, delivery and performance by such Stockholder of this Agreement and the consummation by it of the transactions contemplated hereby have been duly and validly authorized by such Stockholder and no other actions or proceedings on the part of such Stockholder are necessary to authorize the execution and delivery by it of this Agreement and the consummation by it of the transactions contemplated hereby. This Agreement has been duly executed and delivered by such Stockholder, and, assuming this Agreement constitutes a valid and binding obligation of America Online, constitutes a valid and binding obligation of such Stockholder, enforceable against it in accordance with its terms. 2.2 h es. Such Stockholder's Existing Shares are, and all of its Shares from the date hereof through and on the Closing Date will be, owned beneficially and of record by such Stockholder (subject to any dispositions of Shares permitted by Section 3.1(a) hereo fl. As of the date hereof, such Stockholder's Existing Shares constitute all of the shares of Time Warner Common Stock owned of record or beneficially by such Stockholder. Such Stockholder has or will have sole voting power, sole power of disposition, sole power to issue instructions with respect to the matters set forth in Article I hereof, and sole power to agree to all of the matters set 003780-0007-02839-99BG134A-AGR 3 forth in this Agreement, in each case with respect to all of such Stockholder's Existing Shares and with respect to all of such Stockholder's Shares on the Closing Date, with no limitations, qualifications or restrictions on such rights, subject to applicable federal securities laws, the terms of this Agreement and the terms of the Loan Agreement (as defined below in Section 3.1(a)). ARTICLE III OTHER COVENANTS 3.1 Further Agreements of Stockholders. (a) Each Stockholder, severally and not jointly, hereby agrees, while this Agreement is in effect, and except as contemplated hereby, not to sell, transfer, pledge, encumber, assign or otherwise dispose of (collectively, a"Transfer") or enforce or permit the execution of the provisions of any redemption, share purchase or sale, recapitalization or other agreement with Time Wamer or enter into any contract, option or other arrangement or understanding with respect to the offer for sale, sale, transfer, pledge, encumbrance, assignment or other disposition of, any of its Existing Shares, any Shares acquired after the date hereof, any securities exercisable for or convertible into Time Warner Common Stock, any other capital stock of Time Warner or any interest in any of the foregoing with any Person, except to a Person who agrees in writing, in an instrument reasonably acceptable to America Online, to be bound by this Agreement as a Stockholder and be subject to Section 1.1; rovide , however, that the Stockholders collectively may Transfer an aggregate of up to five percent of the Existing Shares held of record by the Stockholders collectively as of the date hereof without compliance with this Section 3.1(a); and provided further that the restrictions contained in this Section 3.1(a) do not apply to Existing Shares now pledged by Stockholders to Merrill Lynch International Bank Limited (the "Bank") to secure a revolving credit facility to R.E. Turner pursuant to that certain Loan and Collateral Account Agreement dated Apri14, 1996, as amended, between the Bank and R.E. Turner (the "Loan Agreement"). (b) In the event of a stock dividend or distribution, or any change in Time Warner Common Stock by reason of any stock dividend or distribution, or any change in Time Warner Common Stock by reason of any stock dividend, split-up, recapitalization, combination, exchange of shares or the like, the term " hares" shall be deemed to refer to and include the Shares as well as all such stock dividends and distributions and any securities into which or for which any or all of the Shares may be changed or exchanged or which are received in such transaction. (c) Each Stockholder covenants and agrees with the other Stockholders and for the benefit of Time Warner (which shall be a third party beneficiary of this Section 3.1(c)) to comply with and perform all its obligations under this Agreement. 003780-0007-02839-99BG134A-AGR 0 ARTICLE IV MISCELLANEOUS 4.1 Termination. This Agreement shall terminate and no party shall have any rights or duties hereunder upon the earlier of (a) the Effective Time or (b) termination of the Merger Agreement pursuant to Secrion 8.1 thereof. Nothing in this Section 4.1 shall relieve or otherwise limit any party of liability for breach of this Agreement. 4.2 Further Assurances. From time to time, at the other party's request and without further consideration, each party hereto shall execute and deliver such additional documents and take all such further action as may be necessary or desirable to consummate the transactions contemplated by this Agreement. 4.3 Notices. All notices and other communications hereunder shall be in writing and shall be deemed duly given (a) on the date of delivery if delivered personally, or by telecopy or telefacsimile, upon confirmation of receipt, (b) on the first Business Day following the date of dispatch if delivered by a recognized next-day courier service, or (c) on the tenth Business Day following the date of mailing if delivered by registered or certified mail, retum receipt requested, postage prepaid. All notices hereunder shall be delivered as set forth below, or pursuant to such other instructions as may be designated in writing by the party to receive such notice: (a) if to America Online to: 22000 AOL Way Dulles, Virginia 20166 Fax: (703) 265-1495 Attention: Paul T. Cappuccio, Senior Vice President and General Counsel with a copy to: Simpson Thacher & Bartlett 425 Lexington Avenue New York, New York 10017 Fax: (212) 455-2502 Attention: Richard I. Beattie, Esq. (b) if to a Stockholder, as provided on the signature page hereof. 4.4 Counter�arts. This Agreement may be executed in one or more counterparts, all of which shall be considered one and the same agreement and shall become 003780-0007-02839-99BG134A-AGR 5 effective when one or more counterparts have been signed by each of the parties and delivered to the other party, it being understood that both parties need not sign the same counterpart. 4.5 Governineg Law. This Agreement shall be governed and construed in accordance with the laws of the State of Delaware (without giving effect to choice of law principles thereo fl. 4.6 Amendment. This Agreement may not be amended except by an instrument in writing signed on behalf of each of the parties hereto. 4.7 Enforcement. The parties agree that irreparable damage would occur in the event that any of the provisions of this Agreement were not performed in accordance with their specific terms. It is accordingly agreed that the parties shall be entitled to specific performance of the terms hereof, this being in addition to any other remedy to which they are entitled at law or in equity. [Remainder of this page intentionally left blank] 003780-0007-02839-99BG134A-AGR IN WITNESS WHEREOF, America Online and each of the Stockholders have caused this Agreement to be signed by their respective officers or other authorized person thereunto duly authorized as of the date first written above. AMERICA ONLINE, INC. By: e: Stephen M. Case Title: Chairman & Chief Executive Officer R.E. Turner III Number of Existing Shares: 95,843,076 Notices Address: One CNN Center Box 105366 Atlanta, GA 30348-5366 Fax: (404) 827-3000 Attention: R.E. Turner III TURNER PARTNERS, L.P. By: Its General Partner By: Name: Title: Number of Existing Shares: 6,028,896 N t'ce Address: One CNN Center Box 105366 Atlanta, GA 30348-5366 Fax: (404) 827-3000 Attention: R.E. Turner III IN ti�'ITi�rESS WHEREOF, America �nline and eacn ot The 5tocl:hold� haL•e caused this Agreement to be signed by their respective officers or other authorizzd �erson ther�unto duly authorized as of the date first wzitten above. A1�IERICA ONLF�IE, n C. By: Name: Title: �'umber of E�isting Sha�•es: 95,S43,U?6 ',`T 1 2S Address: One �NV Center Box 105366 Atlanta, GA 303�3-5366 Fax: i�0a) 827-3�00 Attentior_: R.E. Tum�r III TURNER gy; L Tts eneral P . � $y. � �ame: Title: Number of Existing S}�ar•es: 6,028,896 N�ri ceS Address: One CNti Center Box 1OS366 Atlanta, GA 3t)348-5366 Fax: (404} 327-3000 Attentian: R.E. "Illrner III �cr. ao-oao�-ozaa�-�:s�:3�;-.�� ROBER7 E. 7'URN�R CH. TABL.E RENIAII�D T tIST 2 By: Name: Title: Number of E:cisting Shares: 2,600,993 otices Address: One CNN Ce�iter Box 1OS366 Atlanta, GA 30345-5366 Fax: (404) 327-3000 Attention: R.E. "I�irner :QI TL�2 � Vumber of Existing Shares: 579,884 'ce� Acidress: One C�IN Cer�te�r Box 105366 Atlanta, GA 30348-5366 F�.x: (404) 827-3400 Attenrion: R.E. Tluner lII DJ:i3J-009�-^.7.339-39w15.u-::;t+. EXHIBIT D-1 TO THE MERGER AGREEMENT RESTATED CERTIFICATE OF INCORPOR.ATION OF AOL TIME WARNER INC. ARTICLE I The name of the corporation (hereinafter called the "Corporation") is AOL TIME WARNER INC. ARTICLE II The address of the corporation's registered office in the State of Delaware is 1013 Centre Road, City of Wilmington, County of New Castle. The name of the Corporation's registered agent at such address is Corporation Service Company.. ARTICLE III The purpose of the Corporation is t lawful act or activity for which corporations organized under the General Corporation Law of Delaware. ARTICLE IV o engage in may be the State any of SECTION 1. The total number of shares of all classes of stock which the Corporation shall have authority to issue is 27.55 billion shares, consisting of (1) 750 million shares of Preferred Stock, par value $0.10 per share ("Preferred Stock"), (2) 25 billion shares of Common Stock, par value $0.01 per share("Common Stock"), and (3) 1.8 billion shares of Series Common Stock, par value $0.01 per share ("Series Common Stock"). The number of authorized shares of any of the Preferred Stock, the Common Stock or the Series Common Stock may be increased or decreased (but not below the number of shares thereof then outstanding) by the affirmative vote of the holders of a majority in voting power of the stock of the Corporation entitled to vote thereon irrespective of the provisions of Section 242(b)(2) of the General Corporation Law of the State of Delaware (or any successor provision thereto), and no vote of the holders of any of the Preferred Stock, the Common Stock or the Series Common Stock voting separately as a class shall be required therefor. [NYCorp;987710.4:46�5B:01/12/2000--1:06p1 2 SECTION 2. The Board of Directors is hereby expressly authorized, by resolution or resolutions, to provide, out of the unissued shares of Preferred Stock, for series of Preferred Stock and, with respect to each such series, to fix the number of shares constituting such series and the designation of such series, the voting powers (if any) of the shares of such series, and the preferences and relative, participating, optional or other special rights, if any, and any qualifications, limitations or restrictions thereof, of the shares of such series. The powers, preferences and relative, participating, optional and other special rights of each series of Preferred Stock, and the qualifications, limitations or restrictions thereof, if any, may differ from those of any and all other series at any time outstanding. SECTION 3. The Board of Directors is hereby expressly authorized, by resolution or resolutions, to provide, out of the unissued shares of Series Common Stock, for series of Series Common Stock and, with respect to each such series, to fix the number of shares constituting such series and the designation of such series, the voting powers (if any) of the shares of such series, and the preferences and relative, participating, optional or other special rights, if any, and any qualifications, limitations or restrictions thereof, of the shares of such series. The powers, preferences and relative, participating, optional and other special rights of each series of Series Common Stock, and the qualifications, limitations or restrictions thereof, if any, may differ from those of any and all other series at any time outstanding. SECTION 4. (a) Each holder of Common Stock, as such, shall be entitled to one vote for each share of Common Stock held of record by such holder on all matters on which stockholders generally are entitled to vote; provided, however, that, except as otherwise required by law, holders of Common Stock, as such, shall not be entitled to vote on any amendment to this Restated Certificate of Incorporation (including any Certificate of Designation relating to any series of Preferred Stock or Series Common Stock) that relates solely to the terms of one or more outstanding series of Preferred Stock or �eries Common Stock if the holders of such affected series are entitled, either separately or together with the holders of one or more other such series, to vote thereon pursuant to this Restated Certificate�of Incorporation (including any Certificate of Designation relating to any series of Preferred Stock or Series Common Stock) or pursuant to the General Corporation Law of the State of Delaware. [NYCOrp;9B7710.4:46755:01/12/2000--1:06pJ 3 (b) Except as otherwise required by law, holders of a series of Preferred Stock or Series Common Stock, as such, shall be entitled only to such voting rights, if any, as shall expressly be granted thereto by this Restated Certificate of Incorporation (including any Certificate of Designation relating to such series). (c) Subject to applicable law and the rights, if any, of the holders of any outstanding series of Preferred Stock or Series Common Stock or any class or series of stock having a preference over or the right to participate with the Common Stock with respect to the payment of dividends, dividends may be declared and paid on the Common Stock at such times and in such amounts as the Board of Directors in its discretion shall determine. (d) Upon the dissolution, liquidation or winding up of the Corporation, subject to the rights, if any, of the holders of any outstanding series of Preferred Stock or Series Common Stock or any class or series of stock having a preference over or the right to participate with the Common Stock with respect to the distribution of assets of the Corporation upon such dissolution, liquidation or winding up of the Corporation, the holders of the Common Stock, as such, shall be entitled to receive the assets of the Corporation available for distribution to its stockholders ratably in proportion to the number of shares held by them. SECTION 5. Notwithstanding any other provision of this Restated Certificate of Incorporation to the contrary, but subject to the provisions of any resolution or resolutions of the Board of Directors adopted pursuant to this Article IV creating (i) any series of Preferred Stock, (ii) any series of any other class or series of stock having a preference over the Common Stock as to dividends or upon liquidation or (iii) any series of Series Common Stock, outstanding shares of Common Stock, Series Common Stock, Preferred Stock or any other class or series of stock of the Corporation shall always be subject to redemption by the Corporation, by action of the Board of Directors, if in the judgment of the Board of Directors such action should be taken, pursuant to Section 151(b) of the General Corporation Law of the State of Delaware (or by any other applicable provision of law), to the extent necessary to prevent the loss or secure the reinstatement of any license or franchise from any governmental agency held by the Corporation or any Subsidiary to conduct any portion of the busines� of the Corporation or such Subsidiary, which license or franchise is conditioned upon some or all of the holders of the Corporation's stock of any class or series possessing prescribed qualifications. The terms and conditions of such [NYCOxp;987710.4:4675H:01/12/2000--1:06p) 4 redemption shall be as follows: (a) the redemption price of the shares to be redeemed pursuant to this Section 5 shall be equal to the Fair Market Value of such shares; (b) the redemption price of such shares may be paid in cash, Redemption Securities or any combination thereof ; (c) if less than all the shares held by Disqualified Holders are to be redeemed, the shares to be redeemed shall be selected in such manner as shall be determined by the Board of Directors, which may include selection first of the most recently purchased shares thereof, selection by lot or selection in any other manner determined by the Board of Directors; (d) at least 30 days' written notice of the Redemption Date shall be given to the record holders of the shares selected to be redeemed (unless waived in writing by such holder); provided that the Redemption Date may be the date on which written notice shall be given to record holders if the cash or Redemption Securities necessary to effect the redemption shall have been deposited in trust for the benefit of such record holders and subject to immediate withdrawal by them upon surrender of the stock certificates for their shares to be redeemed; (e) from and after the Redemption Date, any and all rights of whatever nature, which may be held by the owners of shares selected for redemption (including without limitation any rights to vote or participate in dividends declared on stock of the same class or series as such shares), shall cease and terminate and they shall thenceforth be entitled only to receive the cash or Redemption Securities payable upon redemption; and (f) such other terms and conditions as the Board shall determine. For purposes of this Section 5: (i) "Disqualified Holder" shall mean any holder of shares of stock of the Corporation of any class or series whose holding of such stock may result in the loss of any license or franchise from any governmental agency held by the Corporation or any Subsidiary to conduct any portion of the business of the Corporation or any Subsidiary. (NYCOrps987710.�:46�5B:01/12/2000--1:06p] 5 (ii) "Fair Market Value" of a share of the Corporation's stock of any class or series shall mean the average (unweighted) Closing Price for such a share for each of the 45 most recent days on which shares of stock of such class or series shall have been traded preceding the day on which notice of redemption shall be given pursuant to paragraph (d) of this Section 5; provided, however, that if shares of stock of such class or series are not traded on any securities exchange or in the over-the-counter market, "Fair Market Value" shall be determined by the Board of Directors in good faith; and provided further, however, that "Fair Market Value" as to any stockholder who purchased his stock within 120 days of a Redemption Date need not (unless otherwise determined by the Board of Directors) exceed the purchase price paid by him. "Closing Price" on any day means the reported last sales price regular way or, in case no such sale takes place, the average of the reported closing bid and asked prices regular way on the New York Stock Exchange Composite Tape, or, if stock of the class or series in question is not quoted on such Composite Tape, on the New York Stock Exchange, or, if such stock is not listed on such exchange, on the principal United States registered securities exchange on which such stock is listed, or, if such stock is not listed on any such exchange, the highest closing sales price or bid quotation for such stock on The Nasdaq Stock Market or any system then in use, or if no such'prices or quotations are available, the fair market value on the day in question as determined by the Board of Directors in good faith. (iii) "Redemption Date" shall mean the date fixed by the Board of Directors for the redemption of any shares of stock of the Corporation pursuant to this Section 5. (iv) "Redemption Securities" shall mean any debt or equity securities of the Corporation, any Subsidiary or any other corporation, or any combination thereof, having such terms and coilditions as shall be approved by the Board of Directors and which, together with any cash to be paid as part of the redemption price, in the opinion of any nationally recognized investment banking firm selected by the Board of Directors (which may be a firm which provides other investment banking, brokerage or other services to the Corporation), has a value, at the time notice of redemption is given pursuant to paragraph (d) of this Section 5, at least equal to the Fair Market Value of the shares to be redeemed pursuar�t (NYCorp;987710.4:4675B:01/12/2000--1:06p1 6 to this Section 5(assuming, in the case of Redemption Securities to be publicly traded, such Redemption Securities were fully distributed and subject only to normal trading activity). (v) "Subsidiary" shall mean any corporation more than 50s of whose outstanding stock having ordinary voting power in the election of directors is owned by the Corporation, by a Subsidiary or by the Corporation and one or more Subsidiaries. ARTICLE V SECTION 1. Except as otherwise fixed by or pursuant to the provisions of Article IV of this Restated Certificate of Incorporation relating to the rights of the holders of any series of Preferred Stock or Series Common Stock or any class or series of stock having a preference over the Common Stock as to dividends or upon liquidation, the number of the directors of the Corporation shall be fixed from time to time by or pursuant to the By-laws of the Corporation. The directors, other than those who may be elected by the holders of any series of Preferred Stock or Series Common Stock or any class or series of stock having a preference over the Common Stock as to dividends or upon liquidation pursuant to the terms of this Restated Certificate of Incorporation or any resolution or resolutions providing for the issue of such class or series of stock adopted by the Board of Directors, shall be elected by the stockholders entitled to vote thereon at each annual meeting of stockholders and shall hold office until the next annual meeting of stockholders and until each of their successors shall have been elected and qualified. The term of office of each director in office at the time this Section 1 of Article V becomes effective shall expire at the next annual meeting of stockholders held after the time this Section 1 of Article V becomes effective. The election of directors need not be by written ballot. No decrease in the number of directors constituting the Board of Directors shall shorten the term of any incumbent director. SECTION 2. Advance notice of nominations for the election of directors shall be given in the manner and to the extent provided in the By-laws of the Corporation. SECTION 3. Except as otherwise provided for or fixed by or pursuant to the provisions of Article IV of this Restated Certificate of Incorporation relating to the rights of the holders of any series of Preferred Stock or Series Common Stock or any class or series of stock having a [NYCOrp;987710.4:4675B:01/12/2000--1:06p) � preference over the Common Stock as to dividends or upon liquidation, newly created directorships resulting from any increase in the number of directors may be filled by the Board of Directors, or as otherwise provided in the By-laws, and any vacancies on the Board of Directors resulting from death, resignation, removal or other cause shall only be filled by the Board, and not by the stockholders, by �he affirmative vote of a majority of the remaining directors then in office, even though less than a quorum of the Board of Directors, or by a sole remaining director, or as otherwise provided in the By-laws. Any director elected in accordance with the preceding sentence of this Section 3 shall hold office until the next annual meeting of stockholders and until such director's successor shall have been elected and qualified. ARTICLE VI Subject to the rights of the holders of any series of Preferred Stock or Series Common Stock or any class or series of stock having a preference over the Common Stock as to dividends or upon liquidation, any action required or permitted to be taken by the stockholders of the Corporation must be effected at a duly called annual or special meeting of stockholders of the Corporation and may not be effected by any consent in writing by such stockholders. Except as otherwise required by law and subject to the rights of the holders of any series of Preferred Stock or Series Common Stock or any class or se�ies of stock having a preference over the Common Stock as to dividends or upon liquidation, special meetings of stockholders of the Corporation may be called only by the Board of Directors pursuant to a resolution approved by a majority of the entire Board of Directors or as otherwise provided in the By-laws of the Corporation. ARTICLE VII In furtherance and not in limitation of the powers conferred upon it by law, the Board of Directors is expressly authorized to adopt, repeal, alter or amend the By-laws of the Corporation by the vote of a majority of the entire Board of Directors or such greater vote as shall be specified in the By-laws of the Corporation. In addition to any requirements of law and any other provision of this Restated Certificate of Incorporation or any resolution or resolutions of the Board of Directors adopted pursuant to Article IV of this Restated Certificate of Incorporation (and notwithstanding the fact that a lesser percentage may (NYCOrp;987710.4:4675B:01/12/2000--1:06pJ 8 be specified by law, this Restated Certificate of Incorporation or any such resolution or resolutions), the affirmative vote of the holders of 80% or more of the combined voting power of the then outstanding shares of Voting Stock, voting together as a single class, shall be required for stockholders to adopt, amend, alter or repeal any provision of the By-laws. ARTICLE VIII In addition to any requirements of law and any other provisions of this Restated Certificate of Incorporation or any resolution or resolutions of the Board of Directors adopted pursuant to Article IV of this Restated Certificate of Incorporation (and notwithstanding the fact that a lesser percentage may be specified by law, this Restated Certificate of Incorporation or any such resolution or resolutions), the affirmative vote of the holders of 80% or more of the combined voting power of the then outstanding shares of Voting Stock, voting together as a single class, shall be required to amend, alter or repeal, or adopt any provision inconsistent with, this Article VIII or Article VII, or Section 5 of Article IV, of this Restated Certificate of Incorporation. Subject to the foregoing provisions of this Article VIII, the Corporation reserves the right to amend, alter or repeal any provision contained in this Restated Certificate of Incorporation, in the manner now or hereafter prescribed by statute, and all rights conferred upon stockholders herein are subject to this reservation. ARTICLE IX SECTION 1. To the fullest extent that the General Corporation Law of the State of Delaware or any other law of the State of Delaware as it exists or as it may hereafter be amended permits the limitation or elimination of the liability of directors, no director of the Corporation shall be liable to the Corporation or its stockholders for monetary damages for breach of fiduciary duty as a director. No amendment to or repeal of this Article IX shall apply to or have any effect on the liability or alleged liability of any director of the Corporation for or with respect to any acts or omissions of such director occurring prior to such amendment or repeal. SECTION 2. In addition to any requirements of law and any other provisions of this Restated Certificate of Incorporation or any resolution or resolutions of the Board [NYCorp�987730.4:46755:01/12/2000--1:06pJ G� of Directors adopted pursuant to Article IV of this Restated Certificate of Incorporation (and notwithstanding the fact that a lesser percentage may be specified by law, this Restated Certificate of Incorporation or any such resolution or resolutions), the affirmative vote of the holders of 80% or more of the combined voting power of the then outstanding shares of Voting Stock, voting together as a single class, shall be required to amend, alter or repeal, or adopt any provision inconsistent with, this Article IX. [NYCOrp7987710.4:46758:01/12/2000--1:06p] 10 [The provisions of the certificates of designations filed with respect to Time Warner's Series E Convertible Preferred Stock, Series F Convertible Preferred Stock, Series I Convertible Preferred Stock, Series J Convertible Preferred Stock, Series LMC Common Stock and Series LMCN-V Common Stock will be incorporated into P_OL Time Warner Inc.'s Restated Certificate of Incorporation mutatis mutandis. It being understood that the conversion ratio with respect to each such series of Convertible Preferred Stock shall be appropriately adjusted prior to the Effective Time of the Mergers by multiplying the number of shares issuable upon conversion of each share of each such series of Convertible Preferred Stock by the Exchange Ratio. ] (NYCorp;987710.4:46758:01/12/2000--1:06p) EXHIBIT D-2 TO THE MERGER AGREEMENT AOL TIME WARNER INC. BY-LAWS ARTICLE I Offices SECTION l. Registered Office. The registered office of AOL TIME WARNER INC. (hereinafter called the Corporation) in the State of Delaware shall be at 1013 Centre Road, City of Wilmington, County of New Castle, and the registered agent shall be Corporation Service Company, or such other office or agent as the Board of Directors of the Corporation (the "Board") shall from time to time select. SECTION 2. Other Offices. The Corporation may also have an office or offices, and keep the books and records of the Corporation, except as may otherwise be required by law, at such other place or places, either within or without the State of Delaware, as the Board may from time to time determine or the business of the Corporation may require. ARTICLE II Meetings of Stockholders SECTION 1. Place of Meetincr. All meetings of the stockholders of the Corporation (the "stockholders") shall be held seriatim (sequentially) in New York City, NY, Los Angeles, CA, Atlanta, GA and Dulles, VA. SECTION 2. Annual Meetings. The annual meeting of the stockholders for the election of directors and for the transaction of such other business as may properly come before the meeting shall be held on such date and at such hour as shall from time to time be fixed by the Board. Any previously scheduled annual meeting of the stockholders may be postponed by action of the Board taken prior to the time previously scheduled for such annual meeting of stockholders. SECTION 3. Special Meetinas. Except as otherwise required by law or the Restated Certificate of Incorporation of the Corporation (the "Certificate") and subject to the rights of the holders of any series of Preferred Stock or Series Common Stock or any class or series of stock having a preference over the Common Stock as to dividends or upon dissolution, liquidation or winding up, special meetings of [N7CCorp;95d809.8:4605B:01/10/2000--3:45p] E the stockholders for any purpose or purposes may be called by the Chief Executive Officer or a majority of the entire Board. Only such business as is specified in the notice of any special meeting of the stockholders shall come before such meeting. SECTION 4. Notice of Meetinqs. Except as otherwise provided by law, notice of each meeting of the stockholders, whether annual or special, shall be given not less than 10 nor more than 60 days before the date of the meeting to each stockholder of record entitled to notice of the meeting. If mailed, such notice shall be deemed given when deposited in the United States mail, postage prepaid, directed to the stockholder at such stockholder's address as it appears on the records of the Corporation. Each such notice shall state the place, date and hour of the meeting, and, in the case of a special meeting, the purpose or purposes for which the meeting is called. Notice of any meeting of stockholders shall not be required to be given to any stockholder who shall attend such meeting in person or by proxy without protesting, prior to or at the commencement of the meeting, the lack of proper notice to such stockholder, or who shall waive notice thereof as provided in Article X of these By-laws. Notice of adjournment of a meeting of stockholders need not be given if the time and place to which it is adjourned are announced at such meeting, unless the adjournment is for more than 30 days or, after adjournment, a new record date is fixed for the adjourned meeting. SECTION 5. Ouorum. Except as otherwise provided by law or by the Certificate, the holders of a majority of the votes entitled to be cast by the stockholders entitled to vote generally, present in person or by proxy, shall constitute a quorum at any meeting of the stockholders; �rovided, however, that in the case of any vote to be taken by classes or series, the holders of a majority of the votes entitled to be cast by the stockholders of a particular class or series, present in person or by proxy, shall constitute a quorum of such class. SECTION 6. Ad�ournments. The chairman of the meeting or the holders of a majority of the votes entitled to be cast by the stockholders who are present in person or by proxy may adjourn the meeting from time to time whether or not a quorum is present. In the event that a quorum does not exist with respect to any vote to be taken by a particular class or series, the chairman of the meeting or the holders of a majority of the votes entitled to be cast by the stockholders of such class or series who are present in person or by proxy may adjourn the meeting with respect [NYCOrpt954809.8:4605B:01/10/2000--3:45p] to the vote(s) such adjourned business may be at the meeting 3 to be taken by such class or series. At any meeting at which a quorum may be present, any transacted which might have been transacted as originally called. SECTION 7. Order of Business. At each meeting of the stockholders, the Chairman of the Board or, in the absence of the Chairman of the Board, the Chief Executive Officer or, in the absence of the Chairman of the Board and the Chief Executive Officer, such person as shall be selected by the Board shall act as chairman of the meeting. The order of business at each such meeting shall be as determined by the chairman of the meeting. The chairman of the meeting shall have the right and authority to prescribe such rules, regulations and procedures and to do all such acts and things as are necessary or desirable for the proper conduct of the meeting, including, without limitation, the establishment of procedures for the maintenance of order and safety, limitations on the time allotted to questions or comments on the affairs of the Corporation, restrictions on entry to such meeting after the time prescribed for the commencement thereof, and the opening and closing of the voting polls. At any annual meeting of stockholders, only such business shall be conducted as shall have been brought before the annual meeting (i) by or at the direction of the chairman of the meeting or (ii) by any stockholder who is a holder of record at the time of the giving�of the notice provided for in this Section 7, who is entitled to vote at the meeting and who complies with the procedures set forth in this Section 7. For business properly to be brought before an annual meeting by a stockholder, the stockholder must have given timely notice thereof in proper written form to the Secretary of the Corporation (the "Secretary"). To be timely, a stockholder's notice must be delivered to or mailed and received at the principal executive offices of the Corporation not less than 90 days nor more than 120 days prior to the first anniversary of the date of the immediately preceding annual �eeting; provided, however, that in the event that the date of the annual meeting is more than 30 days earlier or more than 60 days later than such anniversary date, notice by the stockholder to be timely must be so delivered or received not earlier than the 120th day prior to such annual meeting and not later than the close of business on the later of the 90th day prior to such annual meeting or the lOth day following the day on which public announcement of the date of such meeting is first made. To be in proper written form, a stockholder's [NYCorpj954809.8:4605B:01/10/2000--3:45p] 4 notice to the Secretary shall set forth in writing as to each matter the stockholder proposes to bring before the annual meeting: (i) a brief description of the business desired to be brought before the annual meeting and the reasons for conducting such business at the annual meeting; (ii) the name and address, as they appear on the Corporation's books, of the stockholder proposing such business; (iii) the class and number of shares of the Corporation which are beneficially owned by�the stockholder; (iv) any material interest of the stockholder in such business; and (v) if the stockholder intends to solicit proxies in support of such stockholder's proposal, a representation to that effect. The foregoing notice requirements shall be deemed satisfied by a stockholder if the stockholder has notified the Corporation of his or her intention to present a proposal at an annual meeting and such stockholder's proposal has been included in a proxy statement that has been prepared by management of the Corporation to solicit proxies for such annual meeting; provided, however, that if such stockholder does not appear or send a qualified representative to present such proposal at such annual meeting, the Corporation need not present such proposal for a vote at such meeting, notwithstanding that proxies in respect of such vote may have been received by the Corporation. Notwithstanding anything in the By-laws to the contrary, no business shall be conducted at any annual meeting except in accordance with the procedures set forth in this Section 7. The chairman of an annual meeting may refuse to permit any business to be brought before an annual meeting which fails to comply with the foregoing procedures or, in the case of a stockholder proposal, if the stockholder solicits proxies in support of such stockholder's proposal without having made the representation required by clause (v) of the second preceding sentence. SECTION 8. List of Stockholders. It shall be the duty of the Secretary or other officer who has charge of the stock ledger to prepare and make, at least 10 days before each meeting of the stockholders, a complete list of the stockholders entitled to vote thereat, arranged in alphabetical order, and showing the address of each stockholder and the number of shares registered in such stockholder's name. Such list shall be produced and kept available at the times and places required by law. SECTION 9. VotinQ. Except as otherwise provided by law or by the Certificate, each stockholder of record of any series of Preferred Stock or Series Common Stock shall be entitled at each meeting of stockholders to such number of votes, if any, for each share of such stock as may be [NYCorpt954809.8:4605B:01/10/2000--3:45p) 5 fixed in the Certificate or in the resolution or resolutions adopted by the Board providing for the issuance of such stock, and each stockholder of record of Common Stock shall be entitled at each meeting of stockholders to one vote for each share of such stock, in each case, registered in such stockholder's name on the books of the Corporation: (1) on the date fixed pursuant to Section 6 of Article VII of these By-laws as the record date for the determination of stockholders entitled to notice of and to vote at such meeting; or (2) if no such record date shall have been so fixed, then at the close of business on the day next preceding the day on which notice of such meeting is given, or, if notice is waived, at the close of business on the day next preceding the day on which the meeting is held. Each stockholder entitled to vote at any meeting of stockholders may authorize not in excess of three persons to act for such stockholder by proxy. Any such proxy shall be delivered to the secretary of such meeting at or prior to the time designated for holding such meeting, but in any event not later than the time designated in the order of business for so delivering such proxies. No such proxy shall be voted or acted upon after three years from its date, unless the proxy provides for a longer period. At each meeting of the stockholders, all corporate actions to be taken by vote of the stockholders (except as otherwise required by law and except as otherwise provided in the Certificate or these By-laws) shall be authorized by a majority of the votes cast by the stockholders entitled to vote thereon who are present in person or represented by proxy, and where a separate vote by class or series is required, a majority of the votes cast by the stockholders of such class or series who are present in person or represented by proxy shall be the act of such class or series. Unless required by law or determined by the chairman of the meeting to be advisable, the vote on any matter, including the election of directors, need not be by written ballot. SECTION 10. Inspectors. The chairman of the meeting shall appoint two or more inspectors to act at any meeting of stockholders. Such inspectors shall perform such duties as shall be required by law or specified by the chairman of the meeting. Inspectors need not be [NYCOrpi954609.8:4605B:01/10/2000--3:45p1 � stockholders. No director or nominee for the office of director shall be appointed such inspector. SECTION 11. Public Announcements. For the purpose of Section 7 of this Article II and Section 3 of Article III, "public announcement" shall mean disclosure (i) in a press release reported by the Dow Jones News Service, Reuters Information Service or any similar or successor news wire service or (ii) in a communication distributed generally to stockholders and in a document publicly filed by the Corporation with the Securities and Exchange Commission pursuant to Sections 13, 14 or 15(d) of the Securities Exchange Act of 1934 or any successor provisions thereto. ARTICLE III Board of Directors SECTION 1. General Powers. The business and affairs of the Corporation shall be managed by or under the direction of the Board, which may exercise all such powers of the Corporation and do all such lawful acts and things as are not by law or by the Certificate directed or required to be exercised or done by the stockholders. SECTION 2. Number. Oualification and Election. Except as otherwise fixed by or pursuant to the provisions of Article IV of the Certificate relating to the rights of the holders of any series of Preferred Stock or Series Common Stock or any class or series of stock having preference over the Common Stock as to dividends or upon dissolution, liquidation or winding up, subject to Section 15 of this Article III, the number of directors constituting the Whole Board shall be determined from time to time by the Board and shall initially be 16. The term "Whole Board" shall mean the total number of authorized directors, whether or not there exist any vacancies or unfilled previously authorized directorships. The directors, other than those who may be elected by the holders of shares of any series of Preferred Stock or Series Common Stock or any class or series of stock having a preference over the Common Stock of the Corporation as to dividends or upon dissolution, liquidation or winding up pursuant to the terms of Article IV of the Certificate or any resolution or resolutions providing for the issuance of such stock adopted by the Board, shall be elected by the stockholders entitled to vote thereon at each annual meeting of the stockholders, and shall hold office until the next - (NYCozp�954809.8:46055:01/10/2000--3:45p] � annual meeting of stockholders and until each of their successors shall have been duly elected and qualified. Each director shall be at least 21 years of age. Directors need not be stockholders of the Corporation. In any election of directors, the persons receiving a plurality of the votes cast, up to the number of directors to be elected in such election, shall be deemed elected. A majority of the members of the Board shall be persons determined by the Board to be eligible to be classified as independent directors. In its determination of a director's eligibility to be classified as an independent director pursuant to this Section 2, the Board shall consider, among such other factors as it may in any case deem relevant, that the director: (i) has not been employed by the Corporation as an executive officer within the past three years; (ii) is not a paid adviser or consultant to the Corporation and derives no financial benefit from any entity as a result of advice or consultancy provided to the Corporation by such entity; (iii) is not an executive officer, director or significant stockholder of a significant customer or supplier of the Corporation; (iv) has no personal services contract with the Corporation; (v) is not an executive officer or director of a tax-exempt entity receiving a significant part of its annual contributions from the Corporation; (vi) is not a member of the immediate family of any director who is not considered an independent director; and (vii) is free of any other relationship that would interfere with the exercise of independent judgment by such director. SECTION 3. Notification of Nominations. Subject to the rights of the holders of any series of Preferred Stock or Series Common Stock or any class or series of stock having a preference over the Common Stock as to dividends or upon dissolution, liquidation or winding up, nominations for the election of directors may be made by the Board or by any stockholder who is a stockholder of record at the time of giving of the notice of nomination provided for in this Section 3 and who is entitled to vote for the election of directors. Any stockholder of record entitled to vote for the election of directors at a meeting may nominate persons for election as directors only if timely written notice of such stockholder's intent to make such nomination is given, either by personal delivery or by United States mail, postage prepaid, to the Secretary. To be timely, a stockholder's notice must be delivered to or mailed and received at the principal executive offices of the (NYCorp�954809.8:46058:01/10/2000--3:45p] Corporation (i) with respect to an ele annual meeting of stockholders, not le than 120 days prior to the first anniv the immediately preceding annual meeti that in the event that the date of the more than 30 days earlier or more than such anniversary date, notice by the s timely must be so delivered or receive 120th day prior to such annual meeting the close of business on the later of such annual meeting or the lOth day fo which public announcement of the date first made and (ii) with respect to an at a special meeting of stockholders f directors, not earlier than the 90th d special meeting and not later than the the later of the 60th day prior to suc the lOth day following the day on whic is first made of the date of the speci nominees to be elected at such meeting shall set forth: (a) the name and add stockholder who intends to make the no � ction to be held at an 5s than 90 nor more �rsary of the date of ng; provided, however, annual meeting is 60 days later than �ockholder to be 3 not earlier than the and not later than �he 90th day prior to llowing the day on �f such meeting is election to be held �r the election of �y prior to such close of business on i special meeting or i public announcement �l meeting and of the Each such notice �ess of the nination and of the person or persons to be nominated; (b) a representation tnat the stockholder is a holder of record of stock of the Corporation entitled to vote at such meeting and intends to appear in person or by proxy at the meeting to nominate the person or persons specified in the notice; (c) a description of all arrangements or understandings between the stockholder and each nominee and any other person or persons (naming such person or persons) pursuant to which the nomination or nominations are to be made by the stockholder; (d) such other information regarding each nominee proposed by such stockholder as would have been required to be included in a proxy statement filed pursuant to the proxy rules of the Securities and Exchange Commission had each nominee been nominated, or intended to be nominated, by the Board; (e) the consent of each nominee to serve as a ciirector of the Corporation if so elected; and (f) if the stockholder intends to solicit proxies in support of such stockholder's nominee(s), a representation to that effect. The chairman of the meeting may refuse to acknowledge the nomination of any person not made in compliance with the foregoing procedure or if the stockholder solicits proxies in favor of such stockholder's nominee(s) without having made the representation required by the immediately preceding sentence. Only such persons who are nominated in accordance with the procedures set forth in this Section 3 shall be eligible to serve as directors of the Corporation. Notwithstanding anything in the immediately preceding paragraph of this Section 3 to the contrary, in [N7fCorpt95l809.8:4605B:01/10/2000--3:45p] � the event that the number of directors to be elected to the Board of Directors of the Corporation at an annual meeting of stockholders is increased and there is no public announcement naming all of the nominees for directors or specifying the size of the increased Board of Directors made by the Corporation at least 90 days prior to the first anniversary of the date of the immediately preceding annual meeting, a stockholder's notice required by this Section 3 shall also be considered timely, but only with respect to nominees for any new positions created by such increase, if it shall be delivered to or mailed to and received by the secretary at the principal executive offices of the Corporation not later than the close of business on the lOth day following the day on which such public announcement is first made by the Corporation. SECTION 4. Ouorum and Manner of Acting. Except as otherwise provided by law, the Certificate or these By- laws, a majority of the Whole Board shall constitute a quorum for the transaction of business at any meeting of the Board, and, except as so provided, the vote of a majority of the directors present at any meeting at which a quorum is present shall be the act of the Board. The chairman of the meeting or a majority of the directors present may adjourn the meeting to another time and place whether or not a quorum is present. At any adjourned meeting at which a quorum is present, any business may be transacted which might have been transacted at the meeting as originally calied. � SECTION 5. Place of MeetinQ. The Board may hold its meetings at such place or places within or without the State of Delaware as the Board may from time to time determine or as shall be specified or fixed in the respective notices or waivers of notice thereof. SECTION 6. Regular Meetings. No fewer than six regular meetings per year of the Board shall be held at such times as the Board shall from time to time by resolution determine, such meetings to be held seriatim (sequentially) in New York City and Northern Virginia. If any day fixed for a regular meeting shall be a legal holiday under the laws of the place where the m�eting is to be held, the meeting which would otherwise be held on that day shall be held at the same hour on the next succeeding business day. SECTION 7. Special Meetinas. Special meetings of the Board shall be held whenever called by the Chairman of the Board, the Chief Executive Officer or by a majority of the directors, and shall be held at such place, on such date and at such time as he or they, as applicable, shall fix. . [NYCOrpt954809.8:46058:01/10/2000--3:45p] � SECTION 8. Notice of Meetings. Notice of regular meetings of the Board or of any adjourned meeting thereof need not be given. Notice of each special meeting of the Board shall be given by overnight delivery service or mailed to each director, in either case addressed to such director at such director's residence or usual place of business, at least two days before the day on which the meeting is to be held or shall be sent to such director at such place by telecopy or by electronic transmission or be given personally or by telephone, not later than the day before the meeting is to be held, but notice need not be given to any director who shall, either before or after the meeting, submit a signed waiver of such notice or who shall attend such meeting without protesting, prior to or at its commencement, the lack of notice to such director. Every such notice shall state the time and place but need not state the purpose of the meeting. SECTION 9. Rules and Requlations. The Board may adopt such rules and regulations not inconsistent with the provisions of law, the Certificate or these By-laws for the conduct of its meetings and management of the affairs of the Corporation as the Board may deem proper. SECTION 10. Participation in Meetincr by Means of Communications Equipment. Any one or more members of the Board or any committee thereof may participate in any meeting of the Board or of any such committee by means of conference telephone or similar communications equipment by means of which all pers�ns participating in the meeting can hear each other or as otherwise permitted by law, and such participation in a meeting shall constitute presence in person at such meeting. SECTION 11. Action Without MeetinQ. Any action required or permitted to be taken at any meeting of the Board or any committee thereof may be taken without a meeting if all of the members of the Board or of any such committee consent thereto in writing or as otherwise permitted by law and, if required by law, the writing or writings are filed with the minutes or proceedings of the Board or of such committee. SECTION 12. Resicxnations. Any director of the Corporation may at any time resign by giving written notice to the Board, the Chairman of the Board, the Chief Executive Officer or the Secretary. Such resignation shall take effect at the time specified therein or, if the time be not specified therein, upon receipt thereof; and, unless otherwise specified therein, the acceptance of such resignation shall not be necessary to make it effective. [NYCorp�959809.8:4605B:01/10/2000--3:45p] 11 SECTION 13. Vacancies. Subject to the rights of the holders of any series of Preferred Stock or Series Common Stock or any class or series of stock having a preference over the Common Stock of the Corporation as to dividends or upon dissolution, liquidation or winding up any vacancies on the Board resulting from death, resignation, removal or other cause shall only be filled by the Board, and not by the stockholders, by the affirmative vote of a majority of the remaining directors then in office, even though less than a quorum of the Board, or by a sole remaining director, and newly created directorships resulting from any increase in the number of directors, which increase shall be subject to Section 15 of this Article III, shall only be filled by the Board, or if not so filled, by the stockholders at the next annual meeting thereof or at a special meeting called for that purpose in accordance with Section 3 of Article II of these By-laws. Any director elected in accordance with the preceding sentence of this Section 13 shall hold office until the next annual meeting of stockholders and until such director's successor shall have been elected and qualified. SECTION 14. Compensation. Each director, in consideration of such person serving as a director, shall be entitled to receive from the Corporation such amount per annum and such fees (payable in cash or stock) for attendance at meetings of the Board or of committees of the Board, or both, as the Board shall from time to time determine. In addition, each director shall be entitled to receive from the Corporation reimbursement for the reasonable expenses incurred by such person in connection with the performance of such person's duties as a director. Nothing contained in this Section shall preclude any director from serving the Corporation or any of its subsidiaries in any other capacity and receiving proper compensation therefor. SECTION 15. Certain Modifications. Notwith- standing anything to the contrary contained in these By-laws, the following actions taken either directly or indirectly by the Board shall require the affirmative vote of not less than 75% of the Whole Board: (i) any change in the size of the Board; and (ii) any proposal to amend these By-laws to be submitted to the stockholders of the Corporation by the Board. �NYCorpj954809.8:46058:01/10/2000--3:45p] 12 ARTICLE IV Committees of the Board of Directors SECTION 1. Establishment of Committees of the Board of Directors: E1 ction of Members of Committees of_the Board of Directors• Functions of Committees of the Board of Directors. (a) The Corporation shall have four standing committees: the nominating and governance committee, the audit and finance committee, the compensation committee and the values and human development committee. (b) The nominating and governance committee shall have the following powers and authority: (i) evaluating and recommending director candidates to the Board, (ii) assessing Board performance not less frequently than every three years, (iii) recommending director compensation and benefits policy for the Corporation, (iv) reviewing individual director performance as issues arise, (v) evaluating and recommending candidates for Chief Executive Officer to the Board and (vi) periodically reviewing the Corporation's corporate governance profile. None of the members of the nominating and governance committee shall be an officer or full-time employee of the Corporation or of any subsidiary or affiliate of the Corporation. _ (c) The audit and finance committee shall have the following powers and authority: (i) employing independent public accountants to audit the books of account, accounting procedures and financial statements of the Corporation and to perform such other duties from time to time as the audit committee may prescribe, (ii) receiving the reports and comments of the Corporation's internal auditors and of the independent public accountants employed by the committee and taking such action with respect thereto as it deems appropriate, (iii) requesting the Corporation's consolidated subsidiaries and affiliated companies to employ independent public accountants to audit their respective books of account, accounting procedures and financial statements, (iv) reguesting the independent public accountants to furnish to the compensation committee the certifications required under any present or future stock option, incentive compensation or employee benefit plan of the Corporation, (v) reviewing the adequacy of ir�ternal financial controls, (vi) approving the accounting principles employed in financial reporting, (vii) approving the appointment or removal of the Corporation's general auditor, (viii) reviewing the accounting principles employed in [NYCozp7954809.8:46058:01/10/2000--3:45p] 13 financial reporting, (ix) reviewing and making recommendations to the Board concerning the financial structure and financial condition of the Company and its subsidiaries, including annual budgets, long-term financial plans, corporate borrowings, investments, capital expenditures, long-term commitments and the issuance of stock and (x) approving such matters that are consistent with the general financial policies and direction from time to time determined by the Board. None of the members of the audit and finance committee shall be an officer or full-time employee of the Corporation or of any subsidiary or affiliate of the Corporation. (d) The compensation committee shall have the following powers and authority: (i) determining and fixing the compensation for all senior officers of the Corporation and its subsidiaries and divisions that the compensation committee shall from time to time consider appropriate, as well as all employees of the Corporation compensated at a rate in excess of such amount per annum as may be fixed or determined from time to time by the Board, (ii) performing the duties of the committees of the Board provided for in any present or future stock option, incentive compensation or employee benefit plan of the Corporation and (iii) reviewing the operations of and policies pertaining to any present or future stock option, incentive compensation or employee benefit plan of the Corporation that the compensation committee shall from time to time consider appropriate. None of the members of the compensation committee shall be an of�icer or full-time employee of the Corporation or of any subsidiary or affiliate of the Corporation. (e) The values and human development committee shall have the following powers and authority: (i) developing and articulating the Corporation's core values, commitments and social responsibilities, (ii) developing strategies for ensuring the Corporation's involvement in the communities in which it does business; (iii) establishing a strategy for developing its human resources and leadership for the future; and (iv) finding practical ways to increase workforce diversity at all levels and to evaluate the Corporation's performance in advancing the goal of greater workforce diversity. (f) Any modification to the powers and authority of any committee shall require the affirmative vote of not less than 75% of the Whole Board. (g) In addition, the Board may, with the affirmative vote of not less than 75°s of the Whole Board and (NfCCOZpJ959809.8:4605B:01/10/2000--3:45p] 14 in accordance with and subject to the General Corporation Law of the State of Delaware, from time to time establish additional committees of the Board to exercise such powers and authorities of the Board, and to perform such other functions, as the Board may from time to time determine. (h) The Board may remove a director from a committee, change the size of any committee or terminate any committee or change the chairmanship of a committee only with the affirmative vote of not less than 75% of the Whole Board. (i) The Board may designate one or more directors as new members of any committee to fill any vacancy on a committee and to fill a vacant chairmanship of a committee, occurring as a result of a member or chairman leaving the committee, whether through death, resignation, removal or otherwise; provided that any such designation or any designation by the Board of a director as an alternate member of any committee in accordance with Section 141(c)(2) of the Delaware General Corporation Law (the "DGCL") may only be made with the affirmative vote of not less than 75% of the Whole Board. SECTION 2. Procedure: Meetinqs: Ouorum. Regular meetings of committees of the Board, of which no notice shall be necessary, may be held at such times and places as shall be fixed by resolution adopted by a majority of the authorized members thereof. Special meetings of any committee of the Board shall be called at the request of any member thereof. Notice of each special meeting of any committee of the Board shall be sent by overnight delivery service, or mailed to each member thereof, in either case addressed to such member at such member's residence or usual place of business, at least two days before the day on which the meeting is to be held or shall be sent to such member at such place by telecopy or by electronic transmission or be given personally or by telephone, not later than the day before the meeting is to be held, but notice need not be given to any member who shall, either before or after the meeting, submit a signed waiver of such notice or who shall attend such meeting without protesting, prior to or at its commencement, the lack of such notice to such member. Any special meeting of any committee of the Board shall be a legal meeting without any notice thereof having been given, if all the members thereof shall be present thereat and no member shall protest the lack of notice to such member. Notice of any adjourned meeting of any committee of the Board need not be given. Any committee of the Board may adopt such rules and regulations not inconsistent with the provisions of law, the Certificate or these By-laws for the [NYCorpt954809.8:46058:01/10/2000--3:45p] 15 conduct of its meetings as such committee of the Board may deem proper. A majority of the authorized members of any committee of the Board shall constitute a quorum for the transaction of business at any meeting, and the vote of a majority of the members thereof present at any meeting at which a quorum is present shall be the act of such committee. Each committee of the Board shall keep written minutes of its proceedings and shall report on such proceedings to the Board. ARTICLE V Officers SECTION l. Number; Term of Office. The officers of the Corporation shall be elected by the Board and shall consist of: a Chairman of the Board, a Chief Executive Officer, two Chief Operating Officers, a Chief Financial Officer and one or more Vice Chairmen and Vice Presidents (including, without limitation, Assistant, Executive, Senior and Group Vice Presidents) and a Treasurer, Secretary and Controller and such other officers or agents with such titles and such duties as the Board may from time to time determine, each to have such authority, functions or duties as in these By-laws provided or as the Board may from time to time determine, and each to hold office for such term as may be prescribed by the Board and until such person's successor shall have been chosen and shall�qualify, or until such person's death or resignation, or until such person's removal in the manner hereinafter provided. The Chairman of the Board, the Chief Executive Officer and the Vice Chairmen shall be elected from among the directors. One person may hold the offices and perform the duties of any two or more of said officers; �rovided, however, that no officer shall execute, acknowledge or verify any instrument in more than one capacity if such instrument is required by law, the Certificate or these By-laws to be executed, acknowledged or verified by two or more officers. The Board may require any officer or agent to give security for the faithful performance of such person's duties. SECTION 2. Removal. Subject to Section 14 of this Article V, any officer may be removed, either with or without cause, by the Board at any meeting thereof called for the purpose or, except in the case of any officer elected by the Board or as provided in Section 4 of this Article V, by any superior officer upon whom such power may be conferred by the Board. (NYCorpt95sB09.8:4605B:01/10/2000--3:45p] 16 SECTION 3. Resignation. Any officer may resign at any time by giving notice to the Board, the Chief Executive Officer or the Secretary. Any such resignation shall take effect at the date of receipt of such notice or at any later date specified therein; and, unless otherwise specified therein, the acceptance of such resignation shall not be necessary to make it effective. SECTION 4. Chairman of the Board. The Chairman of the Board shall be an officer of the Corporation, subject to the control of the Board, and shall report directly to the Board. The Chairman of the Board shall have supervisory responsibility over the functional areas of global public policy (particularly with respect to the Internet), technology policy and future innovation, venture-type investments and philanthropy, operating and discharging those responsibilities with the assistance of the following officers reporting directly to the Chairman of the Board: Kenneth Novack, Kenneth Lerer, George Vradenburg and William Raduchel and their successors (such officers to be appointed and removed only with the Chairman of the Board's approval or upon action of the Board), shall play an active role in helping to build and lead the Corporation, working closely with the Chief Executive Officer to set the Corporation's strategy, and shall be the co-spokesman for the Corporation along with the Chief Executive Officer. SECTION 5. �hief Executive Officer. The Chief Executive Officer shall have general supervision and direction of the business and affairs of the Corporation, subject to the control of the Board and the provisions of Section 4 of this Article V, and shall report directly to the Board. The Chief Executive Officer shall, if present and in the absence of the Chairman of the Board, preside at meetings of the stockholders and of the Board. SECTION 6. Chief OperatinQ Officers. Each Chief Operating Officer shall perform such senior duties in connection with the operations of the Corporation as the Board or the Chief Executive Officer shall from time to time determine, and shall report directly to the Chief Executive Officer. Each Chief Operating Officer, shall, when requested, counsel with and advise the other officers of the Corporation and shall perform such other duties as may be agreed with the Chief Executive Officer or as the Board may from time to time determine. SECTION 7. Vice Chairman. The Vice Chairman shall, when requested, counsel with and advise the other officers of the Corporation and shall perform such other [NYCorpt954809.8:4605B:01/10/2000--3:45p) 17 duties as he may agree with the Chief Executive Officer or as the Board may from time to time determine. SECTION 8. Chief Financial Officer. The Chief Financial Officer shall perform all the powers and duties of the office of the chief financial officer and in general have overall supervision of the financial operations of the Corporation. The Chief Financial Officer shall, when requested, counsel with and advise the other officers of the Corporation and shall perform such other duties as he may agree with the Chief Executive Officer or as the Board may from time to time determine. The Chief Financial Officer shall report directly to the Chief Executive Officer. SECTION 9. Vice-Presidents. Any Vice-President shall have such powers and duties as shall be prescribed by his superior officer or the Board. A Vice President shall, when requested, counsel with and advise the other officers of the Corporation and shall perform such other duties as he may agree with the Chief Executive Officer or as the Board may from time to time determine. A Vice-President need not be an officer of the Corporation. SECTION 10. Treasurer. The Treasurer, if one shall have been elected, shall supervise and be responsible for all the funds and securities of the Corporation; the deposit of all moneys and other valuables to the credit of the Corporation in depositories of the Cor�oration; borrowings and compliance with the provisions of all indentures, agreements and instruments governing such borrowings to which the Corporation is a party; the disbursement of funds of the Corporation and the investment of its funds; and in general shall perform all of the duties incident to the office of the Treasurer. The Treasurer shall, when requested, counsel with and advise the other officers of the Corporation and shall perform such other duties as he may agree with the Chief Executive Officer or as the Board may from time to time determine. SECTION 11. Controller. The Controller shall be the chief accounting officer of the Corporation. The Controller shall, when requested, counsel with and advise the other officers of the CorDOration and shall perform such other duties as he may agree with the Chief Executive Officer or the Chief Financial Officer or as the Board may from time to time detennine. SECTION 12. Secretary. It shall be the duty of the Secretary to act as secretary at all meetings of the Board, of the committees of the Board and of the stockholders and to record the proceedings of such meetings [NYCorp�954809.8:4605H:01/10/2000--3:45p] 18 in a book or books to be kept for that purpose; the Secretary shall see that all notices required to be given by the Corporation are duly given and served; the Secretary shall be custodian of the seal of the Corporation and shall affix the seal or cause it to be affixed to all certificates of stock of the Corporation (unless the seal of the Corporation on such certificates shall be a facsimile, as hereinafter provided) and to all documents, the execution of which on behalf of the Corporation under its seal is duly authorized in accordance with the provisions of these By- laws; the Secretary shall have charge of the books, records and papers of the Corporation and shall see that the reports, statements and other documents required by law to be kept and filed are properly kept and filed; and in general shall perform all of the duties incident to the office of Secretary. The Secretary shall, when requested, counsel with and advise the other officers of the Corporation and shall perform such other duties as he may agree with the Chief Executive Officer or as the Board may from time to time determine. SECTION 13. Assistant Treasurers and Assistant Secretaries. Any Assistant Treasurers and Assistant Secretaries shall perform such duties as shall be assigned to them by the Board. Any Assistant Treasurer or Assistant Secretary shall perform such duties as shall be assigned to them by the Treasurer or Secretary, respectively, or by the Chief Executive Officer. SECTION 14. Certain Actions. Notwithstanding anything to the contrary contained in these By-laws, until December 31, 2003: (i) the removal of Gerald M. Levin from the office of Chief Executive Officer, any modification to the provisions of his employment contract which provide for his term of office or any modification to the role, duties, authority or reporting line of the Chief Executive Officer and (ii) the removal of Stephen M. Case from the office of Chairman of the Board, any modification to the role, duties, authority or reporting line of the Chairman of the Board, each shall require the affirmative vote of 75% of the Whole Board. From and after the end of the period set forth in the preceding sentence, any of the actions set forth in the immediately preceding sentence may be taken upon the affirmative vote of the number of directors which shall constitute, under the terms of these By-laws, the action of the Board. (HYCorps954809.8:96058:01/10/2000--3:45p7 19 ARTICLE VI Indemnification SECTION 1. Right to Indemnification The Corporation, to the fullest extent permitted or required by Delaware General Corporation Law or other applicable law, as the same exists or may hereafter be amended (but, in the case of any such amendment and unless applicable law otherwise requires, only to the extent that such amendment permits the Corporation to provide broader indemnification rights than such law permitted the Corporation to provide prior to such amendment), shall indemnify and hold harmless any person who is or was a director or officer of the Corporation and who is or was involved in any manner (including, without limitation, as a party or a witness) or is threatened to be made so involved in any threatened, pending or completed investigation, claim, action, suit or proceeding, whether civil, criminal, administrative or investigative (including, without limitation, any action, suit or proceedings by or in the right of the Corporation to procure a judgment in its favor) (a "Proceeding") by reason of the fact that such person is or was a director, officer, employee or agent of the Corporation, or is or was serving at the request of the Corporation as a director, officer, employee or agent of another corporation, partnership, joint venture, trust or other enterprise (including, without limitation, any employee benefit plan) (a "Covered Entity") against all expenses (including attorneys' fees), judgments, fines and amounts paid in settlement actually and reasonably incurred by such person in connection with such Proceeding; provided, however, that the foregoing shall not apply to a director or officer of the Corporation with respect to a Proceeding that was commenced by such director or officer unless the proceeding was commenced after a Change in Control (as hereinafter defined in Section 4(e) of this Article). Any director or officer of the Corporation entitled to indemnification as provided in this Section 1 is hereinafter called an "Indemnitee". Any right of an Indemnitee to indemnification shall be a contract right and shall include the right to receive, prior to the conclusion of any Proceeding, payment of any expenses incurred by the Indemnitee in connection with such proceeding, consistent with the provisions of applicable law as then in effect and the other provisions of this Article. SECTION 2. Insurance, Contracts and Fundina. The Corporation may purchase and maintain insurance to protect itself and any director, officer, employee or agent of the Corporation or of any Covered Entity against any expenses, judgments, fines and amounts paid in settlement as specified [NYCOrpr954809.8:4605B:01/10/2000--3:45pj 20 in Section 1 of this Article or incurred by any such director, officer, employee or agent in connection with any Proceeding referred to in Section 1 of this Article, whether or not the Corporation would have the power to indemnify such person against such expense, liability or loss under the DGCL. The Corporation may enter into contracts with any director, officer, employee or agent of the Corporation or of any Covered Entity in furtherance of the provisions of this Article and may create a trust fund, grant a security interest or use other means (including, without limitation, a letter of credit) to ensure the payment of such amounts as may be necessary to effect indemnification as provided or authorized in this Article. SECTION 3. Indemnification Not Exclusive RiQht. The right of indemnification provided in this Article shall not be exclusive of any other rights to which an Indemnitee may otherwise be entitled, and the provisions of this Article shall inure to the benefit of the heirs and legal representatives of any Indemnitee under this Article and shall be applicable to Proceedings commenced or continuing after the adoption of this Article, whether arising from acts or omissions occurring before or after such adoption. SECTION 4. Advancement of Exgenses• Procedures• Presum�tions and Effect of �ertain Proceedinas; Remedies. In furtherance, but not in limitation of the foregoing provisions, the following procedures, presumptions and remedies shall apply with respect to advancement of expenses and the right to indemnification under this Article: (a) Advancement of Expenses. All reasonable expenses (including attorneys' fees) incurred by or on behalf of the Indemnitee in connection with any Proceeding shall be advanced to the Indemnitee by the Corporation within 20 days after the receipt by the Corporation of a statement or statements from the Indemnitee requesting such advance or advances from time to time, whether prior to or after final disposition of such Proceeding. Such statement or statements shall reasonably evidence the expenses incurred by the Indemnitee and, if required by law at the time of such advance, shall include or be accompanied by an undertaking by or on behalf of the Indemnitee to repay the amounts advanced if ultimately it should be determined that the Indemnitee is not entitled to be indemnified against such expenses pursuant to this Article. (b) Procedure for D termination of Entitlement to Indemnification. (i) To obtain indemnification under �NYCorpt954809.8:46058:01/10/2000--3:45p1 21 this Article, an Indemnitee shall submit to the Secretary a written request, including such documentation and information as is reasonably available to the Indemnitee and reasonably necessary to determine whether and to what extent the Indemnitee is entitled to indemnification (the "Supporting Documentation"). The determination of the Indemnitee's entitlement to indemnification shall be made not later than 60 days after receipt by the Corporation of the written request for indemnification together with the Supporting Documentation. The Secretary shall, promptly upon receipt of such a request for indemnification, advise the Board in writing that the Indemnitee has requested indemnification. (ii) The Indemnitee's entitlement to indemnification under this Article shall be determined in one of the following ways: (A) by a majority vote of the Disinterested Directors (as hereinafter defined in Section 4(e) of this Article), whether or not they constitute a quorum of the Board, or by a committee of Disinterested Directors designated by a majority vote of the Disinterested Directors; (B) by a written opinion of Independent Counsel (as hereinafter defined in Section 4(e) of this Article) if (x) a Change in Control (as hereinafter defined in Section 4(e) of this Article) shall have occurred and the Indemnitee so requests or (y) there are no Disinterested Directors or a majority of such Disinterested Directors so directs; (C) by the stockholders of the Corporation; or (D) as provided in Section 4(c) of this Article. (iii) In the event the determination of entitlement to indemnification is to be made by Independent Counsel pursuant to Section 4(b)(ii) of this Article, a majority of the Disinterested Directors shall select the Independent Counsel, but only an Independent Counsel to which the Indemnitee does not reasonably object; provided, however, that if a Change in Control shall have occurred, the Indemnitee shall select such Independent Counsel, but only an Independent Counsel to which a majority of the Disinterested Directors does not reasonably object. (c) Presumptions and Effect of Certain Proceedings. Except as otherwise expressly provided in this Article, if a Change in Control shall have occurred, the Indemnitee shall be presumed to be entitled to indemnification under this Article (with respect to actions or omissions occurring prior to such Change in Control) upon submission of a request for ItiYCorpi954809.8:4605H:01/10/2000--3:45p] 22 indemnification together with the Supporting Documentation in accordance with Section 4(b)(i) of this Article, and thereafter the Corporation shall have the burden of proof to overcome that presumption in reaching a contrary determination. In any event, if the person or persons empowered under Section 4(b) of this Article to determine entitlement to indemnification shall not have been appointed or shall not have made a determination within 60 days after receipt by the Corporation of the request therefor, together with the Supporting Documentation, the Indemnitee shall be deemed to be, and shall be, entitled to indemnification unless �A) the Indemnitee misrepresented or failed to disclose a material fact in making the request for indemnification or in the Supporting Documentation or (B) such indemnification is prohibited by law. The termination of any Proceeding described in Section 1 of this Article, or of any claim, issue or matter therein, by judgment, order, settlement or conviction, or upon a plea of nolo contendere or its equivalent, shall not, of itself, adversely affect the right of the Indemnitee to indemnification or create a presumption that the Indemnitee did not act in good faith and in a manner which the Indemnitee reasonably believed to be in or not opposed to the best interests of the Corporation or, with respect to any criminal proceeding, that the Indemnitee had reasonable cause to believe that such conduct was unlawful. (d) Remedies of Indemnitee. (i) In the event that a determination is made pursuant to Section 4(b) of this Article that the Indemnitee is not entitled to indemnification under this Article, (A) the Indemnitee shall be entitled to seek an adjudication of entitlement to such indemnification either, at the Indemnitee's sole option, in (x) an appropriate court of the State of Delaware or any other court of competent jurisdiction or (y) an arbitration to be conducted by a single arbitrator pursuant to the rules of the American Arbitration Association; (B) any such judicial proceeding or arnitration shall be de novo and the Indemnitee shall not be prejudiced by reason of such adverse determination; and (C) if a Change in Control shall have occurred, in any such judicial proceeding or arbitration, the Corporation shall have the burden of proving that the Indemnitee is not entitled to indemnification under this Article (with respect to actions or omissions occurring prior to such Change in Control). [NYCorpj95�809.8:46058:01/10/2000--3:45p] 23 (ii) If a determination shall have been made or deemed to have been made, pursuant to Section 4(b) or (c) of this Article, that the Indemnitee is entitled to indemnification, the Corporation shall be obligated to pay the amounts constituting such indemnification within five days after such determination has been made or deemed to have been made and shall be conclusively bound by such determination unless (A) the Indemnitee misrepresented or failed to disclose a material fact in making the request for indemnification or in the Supporting Documentation or (B) such indemnification is prohibited by law. In the event that (X) advancement of expenses is not timely made pursuant to Section 4(a) of this Article or (Y) payment of indemnification is not made within five days after a determination of entitlement to indemnification has been made or deemed to have been made pursuant to Section 4(b) or (c) of this Article, the Indemnitee shall be entitled to seek judicial enforcement of the Corporation's obligation to pay to the Indemnitee such advancement of expenses or indemnification. Notwithstanding the foregoing, the Corporation may bring an action, in an appropriate court in the State of Delaware or any other court of competent jurisdiction, contesting the right of the Indemnitee to receive indemnification hereunder, due to the occurrence of an event described in sub-clause (A) or (B) of this clause (ii) (a "Disqualifying Event"); provided, however, that in any such action the Corporation shall have the burden of proving the occurrence of such Disqualifying Event. (iii) The Corporation shall be precluded from asserting in any judicial proceeding or arbitration commenced pursuant to this Section 4(d) that the procedures and presumptions of this Article are not valid,� binding and enforceable and shall stipulate in any such court or before any such arbitrator that the Corporation is bound by all the provisions of this Article. (iv) In the event that the Indemnitee, pursuant to this Section 4(d), seeks a judicial adjudication of or an award in arbitration to enforce rights under, or to recover damages for breach of, this Article, the Indemnitee shall be entitled to recover from the Corporation, and shall be indemnified by the Corporation against, any expenses actually and reasonably incurred by the Indemnitee if the Indemnitee prevails in such judicial adjudication or arbitration. If it shall be determined in such judicial adjudication or arbitration that the Indemnitee is entitled to [NYCOrpj954809.8:46058:01/10/2000--3:45p] 24 receive part but not all of the indemnification or advancement of expenses sought, the expenses incurred by the Indemnitee in cc�nection with such judicial adjudication or arbitration shall be prorated accordingly. (e) Definitions. For purposes of this Section 4: (i) "Authorized Officer" means any one of the Chief Executive Officer, any Chief Operating Officer, the Chief Financial Officer, any Vice President or the Secretary of the Corporation. (ii) "Change in Control" means the occurrence of any of the following (w) any merger or consolidation of the Corporation in which the Corporation is not the continuing or surviving corporation or pursuant to which shares of the Corporation's Common Stock would be converted into cash, securities or other property, other than a merger of the Corporation in which the holders of the Corporation's Common Stock immediately prior to the merger have the same proportionate ownership of common stock of the surviving corporation immediately after the merger, (x) any sale, lease, exchange or other transfer (in one transaction or a series of related transactions) of all, or substantially all, the assets of the Corporation, or the liquidation or dissolution of the Corporation or (y) during any period of two consecutive years, individuals who at the beginning of such period who shall have constituted the entire Board shall have ceased for any reason to constitute a majority thereof unless the election, or the nomination for election by the Corporation's stockholders, of each new director shall have been approved by a vote of at least two- thirds of the directors then still in office who were directors at the beginning of the period. (iii) "Disinterested Director" means a director of the Corporation who is not or was not a party to the Proceeding in respect of which indemnification is sought by the Indemnitee. (iv) "Inde�endent Counsel" means a law firm or a member of a law firm that neither presently is, nor in the past five years has been, retained to represent: (x) the Corporation or the Indemnitee in any matter material to either such party or (y) any other party to the Proceeding giving rise to a claim for indemnification under this Article. Notwithstanding the foregoing, the term "Independent [NYCozp�954809.8:4605H:01/10/2000--3:45p) 25 Counsel" shall not include any person who, under the applicable standards of professional conduct then prevailing under the law of the State of Delaware, would have a conflict of interest in representing either the Corporation or the Indemnitee in an action to determine the Indemnitee's rights under this Article. SECTION 5. Severability. If any provision or provisions of this Article shall be held to be invalid, illegal or unenforceable for any reason whatsoever: (a) the validity, legality and enforceability of the remaining provisions of this Article (including, without limitation, all portions of any paragraph of this Article containing any such provision held to be invalid, illegal or unenforceable, that are not themselves invalid, illegal or unenforceable) shall not in any way be affected or impaired thereby; and (b) to the fullest extent possible, the provisions of this Article (including, without limitation, all portions of any paragraph of this Article containing any such provision held to be invalid, illegal or unenforceable, that are not themselves invalid, illegal or enforceable} shall be construed so as to give effect to the intent manifested by the provision held invalid, illegal or unenforceable. SECTION 6. Indemnification of Em�loyees Servina as Directors. The Corporation, to the fullest extent of the provisions of this Article with respect to the indemnification of directors and officers of the Corporation, shall indemnify any person who is or was an employee of the Corporation and who is or was involved in any manner (including, without limitation, as a party or a witness) or is threatened to be made so involved in any threatened, pending or completed Proceeding by reason of the fact that such employee is or was serving (a) as a director of a corporation in which the Corporation had at the time of such service, directly or indirectly, a 50 percent or greater equity interest (a "Subsidiary Director") and (b) at the written request of an Authorized Officer, as a director of another corporation in which the Corporation had at the time of such service, directly or indirectly, a less than 50 percent equity interest (or no equity interest at all) or in a capacity equivalent to t�at of a director for any partnership, joint venture, trust or other enterprise (including, without limitation, any employee benefit plan) in which the Corporation has an interest (a "Requested Employee"), against all expenses (including attorneys' fees), judgments, fines and amounts paid in settlement actually and reasonably incurred by such Subsidiary Director or Requested Employee in connection with such Proceeding. The Corporation may also advance expenses incurred by any . (NYCOrpj954809.8:4605B:01/10/2000--3:45p] 26 such Subsidiary Director or Requested Employee in connection with any such Proceeding, consistent with the provisions of this Article with respect to the advancement of expenses of directors and officers of the Corporation. SECTION 7. Indemnification of Employees and AQents. Notwithstanding any other provision or provisions of this Article, the Corporation, to the fullest extent of the provisions of this Article with respect to the indemnification of directors and officers of the Corporation, may indemnify any person other than a director or officer of the Corporation, a Subsidiary Director or a Requested Employee, who is or was an employee or agent of the Corporation and who is or was involved in any manner (including, without limitation, as a party or a witness) or is threatened to be made so involved in any threatened, pending or completed Proceeding by reason of the fact that such person is or was a director, officer, employee or agent of a Covered Entity against all expenses (including attorneys' fees), judgments, fines and amounts paid in settlement actually and reasonably incurred by such person in connection with such Proceeding. The Corporation may also advance expenses incurred by such employee or agent in connection with any such Proceeding, consistent with the provisions of this Article with respect to the advancement of expenses of directors and officers of the Corporation. ARTICLE VII Capital Stock SECTION l. Certificates for Shares. The shares of stock of the Corporation shall be represented by certificates, or shall be uncertificated shares that may be evidenced by a book-entry system maintained by the registrar of such stock, or a combination of both. To the extent that shares are represented by certificates, such certificates whenever authorized by the Board, shall be in such form as shall be approved by the Board. The certificates representing shares of stock of each class shall be signed by, or in the name of, the Corporation by the Chairman of the Board, the Chief Executive Officer or any Vice-President and by the Secretary or any Assistant Secretary or the Treasurer or any Assistant Treasurer of the Corporation, and sealed with the seal of the Corporation, which may be a facsimile thereof. Any or all such signatures may be facsimiles if countersigned by a transfer agent or registrar. Although any officer, transfer agent or registrar whose manual or facsimile signature is affixed to such a certificate ceases to be such officer, transfer agent [NYCOrps95�809.9:4605B:01/10/2000--3:45p1 or registrar before such certificate has nevertheless be issued by the Corporation effect as if such officer, transfer agent still such at the date of its issue. 27 been issued, it may with the same or registrar were The stock ledger and blank share certificates shall be kept by the Secretary or by a transfer agent or by a registrar or by any other officer or agent designated by the Board. SECTION 2. Transfer of Shares. Transfers of shares of stock of each class of the Corporation shall be made only on the books of the Corporation upon authorization by the registered holder thereof, or by such holder's attorney thereunto authorized by a power of attorney duly executed and filed with the Secretary or a transfer agent for such stock, if any, and if such shares are represented by a certificate, upon surrender of the certificate or certificates for such shares properly endorsed or accompanied by a duly executed stock transfer power (or by proper evidence of succession, assignment or authority to transfer) and the payment of any taxes thereon; provided, however, that the Corporation shall be entitled to recognize and enforce any lawful restriction on transfer. The person in whose name shares are registered on the books of the Corporation shall be deemed the owner thereof for all purposes as regards the Corporation; provided, however, that whenever any transfer of shares shall be made for collateral security and not absolutely, and written notice thereof shall be given to the Secretary or to such transfer agent, such fact shall be stated in the entry of the transfer. No transfer of shares shall be valid as against the Corporation, its stockholders and creditors for any purpose, except to render the transferee liable for the debts of the Corporation to the extent provided by law, until it shall have been entered in the stock records of the Corporation by an entry showing from and to whom transferred. SECTION 3. Registered Stockholders and Addresses of Stockholders. The Corporation shall be entitled to recognize the exclusive right of a person registered on its records as the owner of shares of stock to receive dividends and to vote as such owner, shall be entitled to hold liable for calls and assessments a person registered on its records as the owner of shares of stock, and shall not be bound to recognize any equitable or other claim to or interest in such share or shares of stock on the part of any other person, whether or not it shall have express or other notice thereof, except as otherwise provided by the laws of Delaware. (NYCorpj954809.8:4605B:01/10/2000--3:45p] 28 Each stockholder shall designate to the Secretary or transfer agent of the Corporation an address at which notices of ineetings and all other corporate notices may be given to such person, and, if any stockholder shall fail to designate such address, corporate notices may be given to such person by mail directed to such person at such person�s post office address, if any, as the same appears on the stock record books of the Corporation or at such person's last known post office address. SECTION 4. Lost. Destroyed and Mutilated Certificates. The holder of any certificate representing any shares of stock of the Corporation shall immediately notify the Corporation of any loss, theft, destruction or mutilation of such certificate; the Corporation may issue to such holder a new certificate or certificates for shares, upon the surrender of the mutilated certificate or, in the case of loss, theft or destruction of the certificate, upon satisfactory proof of such loss, theft or destruction; the Board, or a committee designated thereby, or the transfer agents and registrars for the stock, may, in their discretion, require the owner of the lost, stolen or destroyed certificate, or such person�s legal representative, to give the Corporation a bond in such sum and with such surety or sureties as they may direct to indemnify the Corporation and said transfer agents and registrars against any claim that may be made on account of the alleged loss, theft or destruction of any such certificate or the issuance of such new certificate. SECTION 5. Regulations. The Board may make such additional rules and regulations as it may deem expedient concerning the issue, transfer and registration of certificated or uncertificated shares of stock of each class of the Corporation and may make such rules and take such action as it may deem expedient concerning the issue of certificates in lieu of certificates claimed to have been lost, destroyed, stolen or mutilated. SECTION 6. Fixina Date for Determination of Stockholders of Record. In�order that the Corporation may determine the stockholders entitled to notice of or to vote at any meeting of stockholders or any adjournment thereof, or entitled to receive payment of any dividend or other distribution or allotment or any rights, or entitled to exercise any rights in respect of any change, conversion or exchange of stock or for the purpose of any other lawful action, the Board may fix, in advance, a record date, which shall not be more than 60 nor less than 10 days before the date of such meeting, nor more than 60 days prior to any other action. A determination of stockholders entitled to [NYCOZpj954809.8:46058:01/10/2000--3:45p] 29 notice of or to vote at a meeting of the stockholders shall apply to any adjournment of the meeting; provided, however, that the Board may fix a new record date for the adjourned meeting. SECTION 7. Transfer Agents and Registrars. The Board may appoint, or authorize any officer or officers to appoint, one or more transfer agents and one or more registrars. ARTICLE VIII Seal The Board shall provide a suitable corporate seal, which shall be in the form of a circle and shall bear the full name of the Corporation and shall be in the charge of the Secretary.. The seal may be used by causing it or a facsimile thereof to be impressed or affixed or in any other manner reproduced. ARTICLE IX Fiscal Year The fiscal year of the Corporation shall end on the 31st day of December in each year. ` ARTICLE X Waiver of Notice Whenever any notice whatsoever is required to be given by these By-laws, by the Certificate or by law, the person entitled thereto may, either before or after the meeting or other matter in respect of which such notice is to be given, waive such notice in writing or as otherwise permitted by law, which shall be filed with or entered upon the records of the meeting or the records kept with respect to such other matter, as the case may be, and in such event such notice need not be given to such person and such waiver shall be deemed equivalent to such notice. [NYCorp7954809.8:46058:01/10/2000--3:45pJ I 30 ARTICLE XI Amendments These By-laws may be altered, amended or repealed, in whole or in part, or new By-laws may be adopted by the stockholders or by the Board at any meeting thereof; provided, however, that notice of such alteration, amendment, repeal or adoption of new By-laws is contained in the notice of such meeting of stockholders or in the notice of such meeting of the Board and, in the latter case, such notice is given not less than twenty-four hours prior to the meeting. Unless a higher percentage is required by the Certificate, all such amendments must be approved by either the holders of eighty percent (80s) of the outstanding shares of Voting Stock, voting as a single class, or by a majority of the Board; provided, however, that, notwithstanding the foregoing, until December 31, 2003, the Board may not alter, amend or repeal, or adopt new By-laws in conflict with, or recommend any such action to stockholders, (i) any provision of these By-laws which requires a 75% vote of the Whole Board for action to be taken thereunder or (ii) this Article XI, without the affirmative vote of not less than 75s of the Whole Board. ARTICLE XII Miscellaneous SECTION l. Execution of Documents. The Board or any committee thereof shall designate the officers, employees and agents of the Corporation who shall have power to execute and deliver deeds, contracts, mortgages, bonds, debentures, notes, checks, drafts and other orders for the payment of money and other documents for and in the name of the Corporation and may authorize (including authority to redelegate) by written instrument to other officers, employees or agents of the Corporation. Such delegation may be by resolution or otherwise and the authority granted shall be general or confined to specific matters, all as the Board or any such committee may determine. In the absence of such designation referred to in the first sentence of this Section, the officers of the Corporation shall have such power so referred to, to the extent incident to the normal performance of their duties. SECTION 2. Deposits. All funds of the Corporation not otherwise employed shall be deposited from time to time to the credit of the Corporation or otherwise as the Board or any committee thereof or any officer of the [NYCorpr95l809.8:4605B:01/10/2000--3:45p] Corporation to whom power in respect of shall have been delegated by the Board or in these By-laws shall select. 31 financial operations or any such committee SECTION 3. Checks. All checks, drafts and other orders for the payment of money out of the funds of the Corporation, and all notes or other evidences of indebtedness of the Corporation, shall be signed on behalf of the Corporation in such manner as shall from time to time be determined by resolution of the Board or of any committee thereof or by any officer of the Corporation to whom power in respect of financial operations shall have been delegated by the Board or any such committee thereof or as set forth in these By-laws. SECTION 4. Proxies in Respect of Stock or Other Securities of Other Corporations. The Board or any committee thereof shall designate the officers of the Corporation who shall have authority from time to time to appoint an agent or agents of the Corporation to exercise in the name and on behalf of the Corporation the powers and rights which the Corporation may have as the holder of stock or other securities in any other corporation or other entity, and to vote or consent in respect of such stock or securities; such designated officers may instruct the person or persons so appointed as to the manner of exercising such powers and rights; and such designated officers may execute or cause to be executed in the name and on behalf of the Corporation and under its corporate seal, or otherwise, such written proxies, powers of attorney or other instruments as they may deem necessary or proper in order that the Corporation may exercise its said powers and rights. SECTION 5. Subject to Law and Certificate of Incorporation. All powers, duties and responsibilities provided for in these By-laws, whether or not explicitly so qualified, are qualified by the provisions of the Certificate and applicable laws. [NYCOrpj954809.8:46058:01/10/2000--3:45p] [FORM OF AFFILIATE LETTER] [Holdco] [Address] Ladies and Gentlemen: EXHIBIT 6.11 , 200- Pursuant to the terms of the Agreement and Plan of Merger, dated as of January 10, 2000 (the "Merger AgreemenY'), between America Online, Inc. ("America Online") and Time Warner Inc. ("Time Warne�'), a subsidiary of a newly organized Delawaze corporation ("Holdco") will merge with and into America Online with America Online surviving as a wholly owned subsidiary of Holdco, and another subsidiary of Holdco will merge with and into Time Warner with Time Warner surviving as a wholly owned subsidiary of Holdco (the "Mergers"). Capitalized terms used herein and not defined have the meanings assigned to them in the Merger Agreement. The undersigned has been advised that as of the date the Mergers are submitted to stockholders of America Online or Time Warner, as applicable, for approval, the undersigned may be an"affiliate" of America Online or Time Wamer, as applicable, as the term is defined for purposes of paragraphs (c) and (d) of Rule 145 of the Securities and Exchange Commission (the "Commission") under the Securities Act of 1933, as amended (the "Securities Act"), although nothing contained herein shall be construed as an admission of such fact, or as a waiver of any rights that the undersigned may have to object to any claim that the undersigned is such an affiliate on or after the date of this letter. As a result of the Mergers, the undersigned may receive Holdco Capital Stock or Time Warner Converted Options or America Online Converted Options (collectively, "Holdco Securities"). In respect of shares of Holdco Capital Stock, the undersigned would receive such shares in exchange for shares owned by the undersigned of Time Warner Capital Stock or America Online Common Stock, as applicable. In respect of the options, the undersigned would receive such options in exchange for options held by the undersigned under the Time Warner Stock Option Plans or the America Online Stock Option Plans. 003780-0007-09143-AO:BDSX2-AGR The undersigned hereby represents, warrants and covenants with and to Holdco that in the event the undersigned receives any Holdco Capital Stock as a result of either Merger: (A) The undersigned will not sell, transfer or otherwise dispose of such Holdco Capital Stock unless (i) such sale, transfer or other disposition has been registered under the Securities Act, (ii) such sale, transfer or other disposition is made in conformity with the provisions of Rule 145 under the Securities Act (as such rule may hereafter from time to time be amended), or (iii) in the opinion of counsel in form and substance reasonably satisfactory to Holdco, or under a"no-action" or interpretive letter obtained by the undersigned from the Commission specifically issued with respect to a transaction to be engaged in by the undersigned, such sale, transfer or other disposition will not violate or is otherwise exempt from registration under the Securities Act. (B) The undersigned understands that Holdco is under no obligation to register the sale, transfer or other disposition of shares of Holdco Capital Stock by the undersigned or on the undersigned's behalf under the Securities Act or to take any other action necessary in order to make compliance with an exemption from such registration available solely as a result of the Mergers. (C) The undersigned understands and agrees that this letter agreement shall apply to all shares of the capital stock of Time Warner and America Online that are deemed to be beneficially owned by the undersigned pursuant to applicable federal securities laws. (D) The undersigned has carefully read this letter and discussed its requirements and other applicable limitations upon the undersigned's ability to sell, transfer or otherwise dispose of the capital stock of Holdco, to the extent the undersigned felt necessary, with the undersigned's counsel or counsel for Time Warner and America Online, as applicable. 003790-0007-08143-AO18D5X2-AGR This letter agreement shall be governed by and construed in accordance with the laws of the State of Delaware. This letter agreement shall terminate if and when the Merger Agreement is terminated according to its terms. Very truly yours, Name: [add below the signatures of all registered owners of shares deemed beneficially owned by the affiliate] Name: Name: Name: 003780-0007-08i43-AOI8DSX2-AGR EXHIBIT 7.2(c)(1) [FORM OF REPRESENTATION LETTER] [LETTERHEAD OF HOLDCO (AMERICA ONLINE MERGER)] [Date] Re: The Merger of America Online Merger Sub with and into America Online Simpson Thacher & Bartlett 425 Lexington Avenue New York, New York 10017 Cravath, Swaine & Moore Worldwide Plaza 825 Eighth Avenue New York, New York 10019 Ladies and Gentlemen: In connection with the opinions to be delivered pursuant to the Agreement and Plan of Merger (the "Merger Agreement") dated as of January 10, 2000, between America Online, Inc. ("America Online") and Time Warner Inc. ("Time Warner"), in which America Online Merger Sub ("Sub 1"), a subsidiary of a newly organized Delawaze corporation - ("Holdco"), shall be merged with and into America Online with America Online surviving as a wholly owned subsidiary of Holdco, and Time Warner Merger Sub ("Sub 2"), another subsidiary of Holdco, shall be merged with and into Time Wainer with Time Warner surviving as a wholly owned subsidiary of Holdco, the undersigned certifies and represents on behalf of Holdco and Sub 1, after due inquiry and investigation, as follows (any capitalized term used but not defined herein shall have the meaning given to such teim in the Merger Agreement): 1. The facts relating to the contemplated merger (the "Merger") of Sub 1 with and into America Online pursuant to the Merger Agreement, as described in the Merger Agreement, and the documents described in the Merger Agreement, are, insofar as such facts pertain to Holdco and Sub 1, true, correct and complete in all material respects. The Merger will be consummated in accordance with the Merger Agreement, and as described in the Proxy Statement and the Form S-4, and none of the material terms and conditions therein has been or will be waived or modified. The Merger is being effected for bona fide business reasons. 003�90-0007-00143-AOI8CNJ9-OTH Simpson Thacher & Bartlett -2- Cravath, Swai.ne & Moore [Date) 2. The fair market value of the Holdco Common Stock received by each holder of America Online Common Stock in the Merger will be approxi.mately equal to the fair market value of the America Online Common Stock surrendered by such holders in the Merger. 3. Followi.ng the Merger, America Online will hold at least 90% of the fair mazket value of the net assets and at least 70% of the fair market value of the gross assets held by America Online and Sub 1, as the case may be, immediately prior to the Merger. For purposes of this representation, amounts paid by America Online or Sub 1 to dissenting stockholders of America Online, amounts used by America Online and Sub 1 to pay reorganization expenses incurred in connection with the Merger and all redemptions and distributions (except for regular, normal dividends) made by America Online will be considered assets held by America Online or Sub l, as the case may be, immediately prior to the Merger. 4. Neither Holdco nor any corporation related to Holdco will, in connection with the Merger, (i) be under any obligation or will have entered into any agreement or understanding to redeem or repurchase any of the Holdco Capital Stock issued to stockholders of America Online in the Merger or to make any extraordinary distributions in respect of such Holdco Capital Stock or (ii) have any plan or intention to reacquire any of the Holdco Capital Stock issued in the Merger; provided, however, that Holdco may adopt an open market stock repurchase program that satisfies the requirements of Revenue Ruling 99-58. After the Merger, no dividends or distributions will be made to the former America Online stockholders by Holdco other than regulaz, normal dividends or dis�iburions made to all holders of Holdco Capital Stock: For purposes of this representation letter, two corporations shall be treated as related to one another if im.mediately prior to or immediately after the Merger, (a) the corporations are members of the same affiliated group (within the meani.ng of section 1504 of the Internal Revenue Code of 1986, as amended (the "Code"), but deteimined without regard to the exclusions of section 1504(b) of the Code) or (b) one corporation owns 50% or more of the total combined voting power of all classes of stock of the other corporation that are entitled to vote or 50% or more of the total value of shares of all classes of stock of the other corporation (applying the attriburion rules of section 318 of the Code as modified pursuant to section 304(c)(3)(B) of the Code). For purposes of this representation, a corporation that is a partner in a partnership will be treated as owning or acquiring any stock owned or acquired, as the case may be, by the partnership and as having furnished its share of any consideration fiunished by the partnership to acquire the stock, in each case, in accordance with iu interest in the partnership• 5. Holdco has no present plan or intenrion to (i) liquidate America Online, (ii) merge America Online with or into another corporation, (iii) sell or otherwise dispose of the stock of America Online, except for transfe� (includi.ng successive transfers) of such stock to corporations controlled by the uansferor or (iv) cause America Online to sell or otherwise dispose of any of its assets, or any assets that it acquired from Sub 1, except for dispositions in the ordi.nary course of its business or transfen (includi.ng successive transfers) of assets to one or more corporations controlled in each transfer by the transferor. Holdco has no plan or i.ntention to (i) cause America Onli.ne to issue additional shares of stock following the Merger or (ii) 003780-0007-00143-AOi8CNJ9-0'.H Si�r�on Thacher & Bartlett -3- [Date] Cravath, Swai.ne & Moore otherwise take any action that could result i.n Holdco iosing control of America Online following the Merger. For purposes of this representation letter, control with respect to a corporation shall mean ownership of at least (i) 80% of the total combined voting power of all classes of stock entitled to vote and (ii) 80% of the total number of shazes of each other class of stock of the corporation. 6. Following the Merger, America Onli.ne or another member of America Online's "qualified group" will continue America Onli.ne's historic business or use a significant portion of America Online's historic business assets in a business. For purposes of this representation, America Online's "qualified group" means, pi.usuant to Treasury Regulation section 1.368-1(d)(4)(ii), one or more chai.ns of corporations connected through stock ownership with America Online, but only if America Online owns directly stock representi.ng control in at least one other corporation, and stock representing control in each of the corporations (except America Online) is owned directly by one of the other corporations. In addition, America Online will be treated as owni.ng its proportionate share of America Online's business assets used in a business of any parmership in which members of America Qnline's qualified group either own a significant interest or have active and substantial management functions as a partner with respect to that parniership busi.ness. 7. Prior to the Merger and through the Effective Time, Holdco will own all of the outstanding stock of Sub 1. Holdco has no plan or intention to cause Sub 1 to, and Sub l has no plan or intention to, issue addirional shazes of its stock that would result in Holdco owning less than all of the capital stock of Sub 1 in the Merger. 8. Sub 1 is being formed solely to effect the Merger and it will not conduct any business or other activities other than the issuance of its stock to Holdco prior to the Merger. Sub 1 will have no liabilities that will be assumed by America Online and it will not transfer any assets to America Online in the Merger that aze subject to any liabilities. 9. Pursuant to the Merger, at least (i) 80% of the total combined voting power of all classes of America Online stock entided to vote and (ii) 80% of the total number of shares of each other class of stock of America Online will be exchanged solely for the America Online Merger Consideration. For purposes of this representation, shares of America Online Common Stock exchanged for cash or other property originati.ng with Holdco or Sub 1 will be treated as outstanding America Online Common Stock at the Effecrive Time. 10. Holdco, Sub 1, America Online and the stockholders of America Online will pay their respective expeases, if any, incurred in connection with or as part of the Merger, except that expenses incurred in connection with the filing, printi.ng and mailing of the Joi.nt Proxy Statement/Prospectus and Fotm S-4 will be shared equally by America Online and Time Warner. Neither Holdco nor Sub 1 has agreed to assume, nor will it directly or indirectly assume, any expense or other liability, whether fixed or contingent, of any holder of America Online Common Stock in connection with or as part of the Merger or any related transaction. 003780-0007-00143-A018CNJ9-OTH Simpson Thacher & Bartlett -4- [Date] Cravath, Swaine & Moore Notwithstandi.ng the foregoing, all liability for transfer taxes incurred by a holder of America Online Common Stock will be paid by America Online or stockholders of America Online, and in no event by Holdco. 11. There is no intercorporate indebtedness existing between Holdco or its subsidiaries and America Online or its subsidiaries that was issued, acquired or will be settled at a discount. 12. Neither Holdco nor Sub 1 will (i) elect, or have in effect an election, to be treated as a"regulated investment company" or as a"real estate investment mist" or file any tax return consistent with such treatment or (ii) be a corporation 50% or more of the fair market value of whose total assets are stock or securities and 80% or more of the fair mazket value of whose total assets are assets held for investment. In making the determinations described in (ii) above, (x) the stock and securities of any subsidiary of Holdco or Sub 1 shall be disregarded and Holdco or Sub 1, as the case may be, shall be deemed to own its ratable share of such subsidiary's assets and (y) a corporation shall be considered to be a subsidiary of Holdco or Sub 1, as the case may be, if Holdco and/or Sub 1 owns 50% or more of the combined voting power of all classes of the stock of such subsidiary that are entided to vote, or 50% or more of the total value of all of the outstanding stock of such subsidiary. In addition, in determi.ning the fair mazket value of Holdco's and Sub 1's total assets for the purposes of maki.ng this representation, Holdco and Sub 1 shall exclude any cash and cash items (such as receivables), government securiries and any assets acquired (through incuiring indebtedness or otherwise) for the purposes of causing Holdco or Sub 1 to not be characterized as an entity described in (i) or (ii) of the first sentence of this paragraph or causing Holdco or Sub 1 to meet the requirements of section 368(a)(2)(F�(ii) of the Code. ' 13. As of the Effective Time, neither Holdco nor any corporation related to Holdco will own beneficially, or will have owned beneficially during the five years preced.ing the Effective Time, any shares of stock of America Online or other securities, options, warrants or instruments giving the holder thereof the right to acquire stock of America Online or other securities issued by America Online other than the stock option held by Holdco pursuant to the stock option agreement attached to the Merger Agreement as Exhibit A. 14. The Holdco Common Stock into which America Online Common Stock will be converted in the Merger is entided to vote in the election of directors of Holdco. 15. None of the compensation to be received by any stockholder-employees of America Online for services rendered after the Effective Time will be separate consideration for, or allocable to, any of their shares of America Online Common Stock; none of the Holdco Capital Stock to be received by any stockholder-employees of America Online in connection with the Merger will be separate consideration for, or allocable to, any employment, consulting or si.milar agreement with respect to services performed after the Effective Time; and the compensation paid to any stockholder-employees of America Online for services rendered after 003780-0007-00143-A018CNJ9-OTH Simpson Thacher & Bartlett -5- Cravath, Swaine & Moore [Date] the Effective Ti.me will be for services actually rendered and will be based upon arm's length agreements. 16. After taking into account (a) any issuance of Holdco stock in connection with the Mergers, including (i) stock issued for services, (ii) stock issued upon the the exercise of any Holdco stock rights, options, warrants or subscriptions or (iii) stock issued by public offering or othervvise and (b) to the laiowledge of the management of Holdco, America Online and Time Warner, the sale, exchange, transfer by gift or other disposition, pursuant to an obligation, commitment or understandi.ng binding at the Effective Time of the Mergers, of any Holdco Capital Stock received by holders of Time Warner Capital Stock or America Online Common Stock in the Mergers, the holders of Time Warner Capital Stock and America Online Common Stock will collectively be in control of Holdco within the meani.ng of section 351 of the Code immediately after the Mergers. 17. Holdco will not take any position, and, to the best knowledge of the management of Holdco, there is no plan or intention of any holders of Time Warner or America Online stock to take, any position on any Federal, state or local income or franchise tax return, or to take any other tax reporti.ng position, that is inconsistent with the treamaent of the Merger as an exchange within the meaning of Section 351 of the Code and the regulations promulgated thereunder and as a reorganization within the meaning of Section 368(a) of the Code and the regulations promulgated thereunder. 18. Holdco is not an "investment company" within the meaning of Treasury Regulations secrion 1.351-1(c). 19. The Merger Agreement, the documents described in the Merger Agreement, the Proxy Statement, and the Form S-4 represent the entire understandi.ng between or among (i) Holdco and its subsidiaries, (ii) Time Warner and its subsidiaries and (iii) America Online and its subsidiaries and, to the best knowledge of the management of Holdco, between or among such entities and the affiliates and stockholders of Holdco, Time Warner' and America pnline with respect to the Merger, and there are no other written or oral agreemeats regarding the Merger other than those expressly referred to in the Merger Agreement, the Proxy Statement and the Form S-4. 20. The undersigned are authorized to make all the representations set forth herein on behalf of Holdco. Very truly yours, Holdco 003780-0007-00143-A0:8CNJ9-OTH Simpson Thacher & Bartlett -6- Cravath, Swaine & Moore : Title: By: Title: 003790-0007-00143-A018CNJ9-0?H [Date] EXHIBIT 7.2(c)(1) [FORM OF REPRESENTATION LETTERJ [LETTERHEA.D OF HOLDCO (TIME WARNER MERGER)) [DateJ Re: The Merger of Time Warner Merger Sub with and into Time Warner Simpson Thacher & Bartlett 425 Lexington Avenue New York, New York 10017 Cravath, Swaine & Moore Worldwide Plaza 825 Eighth Avenue New York, New York 10019 Ladies and Gentlemen: In connection with the opinions to be delivered pursuant to the Agreement and Plan of Merger (the "Merger Agreement") dated as of January 10, 2000, between America Online, Inc. ("America Online") and Time Warner Inc. ("Time Warner"),in which America Online Merger Sub ("Sub 1"), a subsidiary of a newly organized Delaware corporation ("Holdco"), shall be merged with and into America Online with America Online surviving as a wholly owned subsidiary of Holdco, and Time Warner Merger Sub ("Sub 2"), another subsidiary of Holdco, shall be merged with and into Time Wamer with Time Wamer surviving as a wholly owned subsidiary of Holdco, the undersigned certifies and represents on behalf of Holdco and Sub 2, after due inquiry and investigation, as follows (any capitalized term used but not defined herein shall have the meaning given to such term in the Merger Agreement): 1. The facts relating to the contemplated merger (the "Merger") of Sub 2 with and into Time Warner pursuant to the Merger Agreement, as described in the Merger Agreement, and the documents described in the Merger Agreement, are, insofar as such facts pertain to Holdco and Sub 2, true, correct and complete in all material respects. The Merger will be consummated in accordance with the Merger Agreement, and as described in the Proxy Statement and the Form S-4, and none of the material terms and conditions therein has been or will be waived or modified. The Merger is being effected for bona fide business reasons. 2. The fair market value of the Holdco Common Stock and cash in lieu of a fractional share of Holdco Common Stock received by each holder of Time Warner Common 003780-000�-00!43-A019CVA9-OTH Simpson Thacher & Bartlett -2- [Date] Cravath, Swaine & Moore Stock in the Merger will be approximately equal to the fair market value of the Time Warner Common Stock surrendered by such holders in the Merger. The fair market value of Holdco Series LMCN-V Common Stock and cash in lieu of a fractional share of Holdco Series LMCN-V Common Stock received by each holder of Time Warner Series LMCN-V Common Stock in the Merger will be approximately equal to the fair market value of the Time Warner Series LMCN-V Common Stock surrendered by such holders in the Merger. The fair market value of Holdco Series LMC Common Stock and cash in lieu of a fractional share of Holdco Series LMC Common Stock received by each holder of Time Warner Series LMC Common Stock in the Merger will be approximately equal to the fair market value of the Time Wamer Series LMC Common Stock surrendered by such holders in the Merger. The fair market value of Holdco Series E Preferred Stock received by each holder of Time Warner Series E Preferred Stock in the Merger will be approximately equal to the fair market value of the Time Warner Series E Preferred Stock surrendered by such holders in the Merger. The fair market value of Holdco Series F Preferred Stock received by each holder of Time Warner Series F Preferred Stock in the Merger will be approximately equal to the fair market value of the Time Warner Series F Prefened Stock surrendered by such holders in the Merger. The fair market value of Holdco Series I Preferred Stock received by each holder of Time Wamer Series I Preferred Stock in the Merger will be approximately equal to the fair market vaeieThe fair marketavalue of1Holdco Preferred Stock surrendered by such holders in the Merg Series J Preferred Stock received by each holder of Time Warner Series J Preferred Stock in the Merger will be approximately equal to the fair market value of the Time Warner Series J Preferred Stock surrendered by such ldco Ser es LMC Common Stockc Holdco Series E� Holdco Series LMCN-V Common Stock, Ho Preferred Stock, Holdco Series F Preferred Stock, Holdco Series I Preferred Stock and Holdco Series J Preferred Stock aze referred to collectively herein as the "Holdco Capital Stock". The Time Warner Common Stock, Time Warner Series LMCN-V Common Stock, Time Wamer Series LMC Common Stock, Time Warner Series E Preferred Stock, Time Warner Series F Preferred Stock, Time Warner Series I Preferred Stock and Time Warner Series J Preferred Stock are referred to collectively herein as the "Time Warner Capital Stock". The Merger Consideration to be received in the Merger by holders of Time Wamer Capital Stock was determined by arm's length negotiations between the managements of Alpha and Time Warner. In connection with the Merger, no holder of Time Warner Capital Stock will receive in exchange for Time Warner Capital Stock, directly or indirectly, any consideration from Holdco or Sub 2 other than Holdco Capital Stock and cash in lieu of a fractional shaze thereof. 3. Following the Merger, Time Warner will hold at least 90% of the fair market value of the net assets and at least 70% of the fair market value of the gross assets held by Time Warner and Sub 2, as the case may be, unmediately prior to the Merger. For purposes of this representation, amounts paid by Time Warner or Sub 2 to dissenting stockholders of Time Warner, amounts used by Time Warner and Sub 2 to pay reorganization exper�ses incurred in connection with the Merger and all redemptions and distributions (except for regular, normal dividends) made by Time Warner will be considered assets held by Time Warner or Sub 2, as the case may be, immediately prior to the Merger. oo3�eo-000�-ooia3-aoiecvna-oiH Simpson Thacher & Bartlett -3- [DateJ Cravath, Swaine & Moore 4. Neither Holdco nor any corporation related to Holdco will, in connection with the Merger, (i) be under any obligation or will have entered into any agreement or understanding to redeem or repurchase any of the Holdco Capital Stock issued to stockholders of Time Warner in the Merger or to make any extraordinary distributions in respect of such Holdco Capital Stock or (ii) have any plan or intention to reacquire any of the Holdco Capital Stock issued in the Merger; provided, however, that Holdco may adopt an open market stock repurchase program that satisfies the requirements of Revenue Ruling 99-58 and may redeem Holdco preferred stock issued in the Merger pursuant to the terms of such preferred stock. After the Merger, no dividends or distributions will be made to the former Time Warner stockholders by Holdco other than regular, normal dividends or distributions made to all holders of Holdco Capital Stock. For purposes of this representation letter, two corporations shall be treated as related to one another if immediately prior to or immediately after the Merger, (a) the corporations are members of the same affiliated group (within the meaning of section 1504 of the Internal Revenue Code of 1986, as amended (the "Code"), but determined without regard to the exclusions of section 1504(b) of the Code) or (b) one corporation owns 50% or more of the total combined voting power of all classes of stock of the other corporation that are entitled to vote or 50% or more of the total value of shazes of all classes of stock of the other corporation (applying the attribution rules of section 318 of the Code as modified pursuant to section 304(c)(3)(B) of the Code). For purposes of this representation, a corporation that is a partner in a partnership will be treated as owning or acquiring any stock owned or acquired, as the case may be, by the partriership and as having furnished its share of any consideration furnished by the partnership to acquire the stock, in each case, in accordance with its interest in the partnership. 5. Holdco has no present plan or intention to (i) liquidate Time Warner, (ii) merge Time Warner with or into another corporation, (iii) sell or otherwise dispose of the stock of Time Warner, except for transfers (including successive transfers) of such stock to corporations controlled by the transferor or (iv) cause Time Warner to sell or otherwise dispose of any of its assets, or any assets that it acquired from Sub 2, except for dispositions in the ordinary course of its business or transfers (including successive transfers) of assets to one or more corporations controlled in each transfer by the transferor. Holdco has no plan or intention to (i) cause Time Warner to issue additional shares of stock following the Merger or (ii) otherwise take any action that could result in Holdco losing control of Time Wamer following the Merger. For purposes of this representation letter, control with respect to a corporation shall mean ownership of at least (i) 80% of the total combined voting power of all classes of stock entitled to vote and (ii) 80% of the total number of shares of each other class of stock of the corporation. 6. Following the Merger, Time Warner or another member of Time Wamer's "qualified group" will continue Time Warner's historic business or use a significant portion of Time Warner's historic business assets in a business. For purposes of this representation, Time Warner's "qualified group" means, pursuant to Treasury Regulation section 1.368-1(d)(4)(ii), one or more chains of corporations connected through stock ownership with Time Warner, but only if Time Warner owns directly stock representing control in at least one other corporation, 003780-0007-00143-�O18CVA4-OTH Simrson Thacher & Bartlett -4- Cravath, Swaine & Moore [DateJ and stock representing control in each of the corporations (except Time Warner) is owned directly by one of the other corporations. In addition, Time Wamer will be treated as owning its proportionate share of Time Warner's business assets used in a business of any partnership in which members of Time Warner qualified group either own a significant interest or have active and substantial management functions as a partner with respect to that partnership business. 7. Prior to the Merger and through the Effective Time, Holdco will own all of the outstanding stock of Sub 2. Holdco has no plan or intention to cause Sub 2 to, and Sub 2 has no plan or intention to, issue additional shares of its stock that would result in Holdco owning less than all of the capital stock of Sub 2 in the Merger. 8. Sub 2 is being formed solely to effect the Merger and it will not conduct any business or other activities other than the issuance of its stock to Holdco prior to the Merger. Sub 2 will have no liabilities that will be assumed by Time Warner and it will not transfer any assets to Time Warner in the Merger that are subject to any liabilities. 9. Pursuant to the Merger, at least (i) 80% of the total combined voting power of all classes of Time Wamer stock entitled to vote and (ii) 80% of the total number of shares of each other class of stock of Time Wamer will be exchanged solely for the Time Warner Merger Consideration. For purposes of this representation, shares of Time Warner Capital Stock exchanged for cash or other property originating with Holdco or Sub Z will be treated as outstanding Time Warner Capital Stock at the Effective Time. 10. Holdco, Sub 2, Time Wamer and the stockholders of Time Warner will pay their respective expenses, if any, incurred in connection with or as part of the Merger, except that expenses incurred in connection with the filing, printing and mailing of the Joint Proxy StatementlProspectus and Form S-4 will be shared equally by Alpha and Time Warner. Neither Holdco nor Sub 2 has agreed to assume, nor will it directly or indirectly assume, any expense or other liability, whether fixed or contingent, of any holder of Time Warner Capital Stock in connection with or as part of the Merger or any related transaction. Notwithstanding the foregoing, all liability for transfer taxes incurred by a holder of Time Warner Capital Stock will be paid by Time Wamer or stockholders of Time Warner, and in no event by Holdco. 11. There is no intercorporate indebtedness existing between Holdco or its subsidiaries and Time Wamer or its subsidiaries that was issued, acquired or will be settled at a discount. 12. Neither Holdco nor Sub 2 will (i) elect, or have in effect an election, to be treated as a"regulated investment company" or as a"real estate investment trust" or file any tax return consistent with such treatment or (ii) be a corporation 50% or more of the fair market value of whose total assets are stock or securities and 80% or more of the fair market value of whose total assets are assets held for investment. In making the determinations described in (ii) above, (x) the stock and securities of any subsidiary of Holdco or Sub 2 shall be disregarded and 003780-0007-00143-A018CVA4-OTH Simpson Thacher & Bartlett -5- [Date) Cravath, Swaine & Moore Holdco or Sub 2, as the case may be, shall be deemed to own its ratable share of such subsidiary's assets and (y) a corporation shall be considered to be a subsidiary of Holdco or Sub 2, as the case may be, if Holdco and/or Sub 2 owns 50% or more of the combined voting power of all classes of the stock of such subsidiary that are entitled to vote, or 50% or more of the total value of all of the outstanding stock of such subsidiary. In addition, in determining the fair mazket value of Holdco's and Sub 2's total assets for the purposes of making this representation, Holdco and Sub 2 shall exclude any cash and cash items (such as receivables), government securities and any assets acquired (through incurring indebtedness or otherwise) for the purposes of causing Holdco or Sub 2 to not be characterized as an entity described in (i) or (ii) of the first sentence of this pazagraph or causing Holdco or Sub 2 to meet the requirements of section 368(a)(2)(F)(ii) of the Code. 13. As of the Effective Time, neither Holdco nor any corporation related to Holdco will own beneficially, or will have owned beneficially during the five yeazs preceding the Effective Time, any shares of stock of Time Warner or other securities, options, warrants or instruments giving the holder thereof the right to acquire stock of Time Warner or other securities issued by Time Warner other than the stock option held by Holdco pursuant to the stock option agreement attached to the Merger Agreement as Exhibit A. 14. Each class of Holdco Capital Stock into which Time Warner Capital Stock will be converted in the Merger is entitled to vote in the election of directors of Holdco. 15. None of the compensation to be received by any stockholder-employees of Time Wamer for services rendered after the Effective Time will be separate consideration for, or allocable to, any of their shares of Time Warner Capital Stock; none of the Holdco Capital Stock to be received by any stockholder-employees of Time Warner in connection with the Merger will be separate consideration for, or allocable to, any employment, consulting or similar agreement with respect to services rendered after the Effective Time; and the compensation paid to any stockholder-employees of Time Warner for services rendered after the Effective Time will be for services actually rendered and will be based upon arms-length agreements. 16. The payment of cash in lieu of fractional shares of Holdco is solely for the purpose of avoiding the expense and inconvenience to Holdco of issuing fractional shazes and does not represent sepazately bargained-for consideration. 17. After taking into account (a) any issuance of Holdco stock in connection with the Mergers, including (i) stock issued for services, (ii) stock issued upon the the exercise of any Holdco stock rights, options, warrants or subscriptions or (iii) stock issued by public offering or otherwise and (b) to the knowledge of the management of Holdco, Time Warner and Alpha, the sale, exchange, transfer by gift or other disposition, pursuant to an obligation, commitment or understanding binding at the Effective Time of the Mergers, of any Holdco Capital Stock received by holders of Time Warner Capital Stock or Alpha Common Stock in the Mergers, the 003780-0007-00143-AOI8CVA4-OTH Simpson Thacher & Bartlett -6- Cravath, Swaine & Moore [Date] holders of Time Wamer Capital Stock and Alpha Common Stock will collectively be in control of Holdco within the meaning of section 351 of the Code immediately after the Mergers. 18. Holdco will not take any position, and, to the best knowledge of the management of Holdco, there is no plan or intention of any holders of Time Warner or Alpha stock to take, any position on any Federal, state or local income or franchise tax return, or to take any other tax reporting position, that is inconsistent with the treatment of the Merger as an exchange within the meaning of Section 351 of the Code and the regulations promulgated thereunder and as a reorganization within the meaning of Section 368(a) of the Code and the regulations promulgated thereunder. 19. Holdco is not an "investment company" within the meaning of Treasury Regulations section 1.351-1(c). 20. The Merger Agreement, the documents described in the Merger Agreement, the Proxy Statement, and the Form S-4 represent the entire understanding between or among (i) Holdco and its subsidiaries, (ii) Alpha and its subsidiaries and (iii) Time Warner and its subsidiaries and, to the best knowledge of the management of Holdco, between or among such entities and the affiliates and stockholders of Holdco, Alpha and Time Warner with respect to the Merger, and there are no other written or oral agreements regarding the Merger other than those expressly referred to in the Merger Agreement, the Proxy Statement and the Form S-4. 21. The undersigned are authorized to make all the representations set forth herein on behalf of Holdco. Very truly yours, Holdco By: Title: By: Title: oo3�ao-000�-oo:a3-AOiecvAa-oTK EXHIBIT 7.2(c)(2) [FORM OF REPRESENTATION LETTER] [LETTERHEAD OF AMERICA ONLINE, INC.] [Date] Re: The Merger of America Online Merger Sub with and into America Online. Inc. Simpson Thacher & Bartlett 425 Lexington Avenue New York, New York 10017 Cravath, Swaine & Moore Worldwide Plaza 825 Eighth Avenue New York, New York 10019 Ladies and Gentlemen: In connection with the opinions to be delivered pursuant to the Agreement and Plan of Merger (the "Merger Agreement") dated as of January 10, 2000, between America Online, Inc. ("America Online") and Time Warner Inc. ("Time Warner"), in which America Online Merger Sub ("Sub 1"), a subsidiary of a newly organized Delaware corporation ("Holdco"), shall be merged with and into America Online with America Online surviving as a wholly owned subsidiary of Holdco, and Time Warner Merger Sub ("Sub 2"), another subsidiary of Holdco, shall be merged with and into Time Warner with Time Warner surviving as a wholly ovcmed subsidiary of Holdco, the undersigned certifies and represents on behalf of America Online, after due inquiry and investigation, as follows (any capitalized term used but not defined herein shall have the meaning given to such term in the Merger Agreement): 1. The facts relating to the contemplated merger (the "Merger") of Sub 1 with and into America Online pursuant to the Merger Agreement, as described in the Merger Agreement, and the documents described in the Merger Agreement, are, insofar as such facts pertain to America Online, true, correct and complete in all material respects. The Merger will be consummated in accordance with the Merger Agreement, and as described in the Proxy Statement and the Form S-4, and none of the material terms and conditions therein has been or will be waived or modified. The Merger is being effected for bona fide business reasons. 2. The fair market value of the Holdco Common Stock received by each holder of America Online Common Stock in the Merger will be approximately equal to the fair 00379C-0007-OC143-AO.ac-�c-o:� Simpson Thacher & Bartlett -2- Cravath, Swaine & Moore [Date] market value of the America Online Common Stock surrendered by such holders in the Merger. The America Online Merger Consideration to be received in the Merger by holders of America Online Common Stock was determined by arm's length negotiations between the managements of Time Warner and America Online. In connection with the Merger, no holder of America Online Common Stock will receive in exchange for America Online Common Stock, directly or indirectly, any consideration from Holdco or Sub lother than Holdco Common Stock. 3. America Online, prior to and in connection with the Merger, has not redeemed any of its stock or made any distributions with respect to its stock. Additionally, prior to and in connection with the Merger, no corporation related to America Online has acquired America Online's stock with consideration other than stock of either America Online or Holdco. For purposes of this representation letter, two corporations shall be treated as related to one another if immediately prior to or immediately after the Merger, (a) the corporations are members of the same affiliated group (within the meaning of section 1504 of the Internal Revenue Code of 1986, as amended (the "Code"), but determined without regard to the exclusions of section 1504(b) of the Code) or (b) one corporation owns 50% or more of the total combined voting power of all classes of stock of the other corporation that are entitled to vote or 50% or more of the total value of shares of all classes of stock of the other corporation (applying the attribution rules of section 318 of the Code as modified pursuant to section 304(c)(3)(B) of the Code). For purposes of this representation, a corporation that is a partner in a partnership will be treated as owning or acquiring any stock owned or acquired, as the case may be, by the partnership and as having furnished its share of any consideration furnished by the partnership to acquire the stock, in each case, in accordance with its interest in the partnership. 4. To the best knowledge of the management of America Online, there is no plan or intention on the part of holders of America Online Common Stock to sell, exchange or otherwise transfer ownership (including by derivative transactions such as an equity swap which would have the economic effect of a transfer of ownership) to Holdco, America Online or any person related to Holdco or America Online, directly or indirectly (including through partnerships or through third parties in connection with a plan to so transfer ownership), of any shares of Holdco Common Stock. 5. Following the Effective Time of the Merger, America Online will hold at least 90% of the fair market value of the net assets and at least 70% of the fair market value of the gross assets held by America Online immediately prior to the Merger. For purposes of this representation, amounts paid by America Online or Sub 1 to dissenting stockholders of America Online, amounts used by America Online and Sub 1 to pay reorganization expenses and all redemptions and distributions (except for regular, normal dividends) made by America Online will be considered assets held by America Online or Sub 1, as the case may be, immediately prior to the Merger. Any dispositions of assets held by America Online prior to the Merger which are made in contemplation of, or as part of, the Merger will be for fair market value, and the proceeds thereof will be retained by America Online. oo3�ao-000�-oo� a3-�oiac.7r•x-o-:; Simpson Thacher & Bartlett -3- Cravath, Swaine & Moore [Date] 6. At the Effective Time of the Merger, America Online will be conducting America Online's historic business or using a significant portion of America Online's historic business assets in a business. 7. Pursuant to the Merger, at least (i) 80% of the total combined voting power of all classes of America Online stock entitled to vote and (ii) 80% of the total number of shares of each other class of stock of America Online will be exchanged solely for the America Online Merger Consideration. For purposes of ihis representation, shazes of America Online Common Stock exchanged for cash or other property originating with Holdco or Sub 1 will be treated as outstanding America Online Common Stock at the Effective Time. 8. At the Effective Time, America Online will not have any warrants, options, convertible securities or any other type of right pursuant to which any person could acquire any stock of America Online which, if exercised or converted, would affect Holdco's ability to acquire or retain control of America Online. For purposes of this representation letter, "control" with respect to a corporation shall mean ownership of at least (i) 80% of the total combined voting power of all classes of stock entitled to vote and (ii) 80% of the total number of shares of each other class of stock of the corporation. 9. Prior to the Effective Time, America Online has no plan or intention to issue any additional shares of stock that would cause Holdco to own less than (i) 80% of the total combined voting power of all classes of America Online stock entitled to vote or (ii) 80% of the total number of shares of each other class of stock of America Online. 10. Holdco, Sub 1, America Online and the stockholders of America Online will pay their respective expenses, if any, incurred in connection with or as part of the Merger, except that expenses incurred in connection with the filing, printing and mailing of the Joint Proxy Statement/Prospectus and Form S-4 will be shared equally by America Online and Time Warner. America Online has not agreed to assume, nor will it directly or indirectly assume, any expense or other liability, whether fixed or contingent, of any holder of America Online Common Stock in connection with or as part of the Merger or any related transactions. Notwithstanding the foregoing, all liability for transfer taxes incurred by a holder of America Online Common Stock will be paid by America Online or stockholders of America Online, and in no event by Holdco. 11. There is no intercorporate indebtedness existing between Holdco or its subsidiaries and America Online or its subsidiaries that was issued, acquired or will be settled at a discount. 12. America Online will not (i) elect, or have in effect an election, to be treated as a"regulated investment company" or as a"real estate investment trust" or file any tax return consistent with such treatment or (ii) be a corporation 50% or more of the fair market value of whose total assets are stock or securities and 80% or more of the fair market value of • 0037 80-�007-0014 3-A01 BC,TADC-OTH Simpson Thacher & Bartlett -4- [DateJ Cravath, Swaine & Moore whose total assets are assets held for investment. In making the determinations described in (ii) above, (x) the stock and securities of any subsidiary of America Online shall be disregarded and America Online shall be deemed to own its ratable share of such subsidiary's assets and (y) a corporation shall be considered to be a subsidiary of America Online, if America Online owns 50% or more of the combined voting power of all classes of the stock of such subsidiary that are entitled to vote, or 50% or more of the total value of all of the outstanding stock of such subsidiary. In addition, in determining the fair market value of America Online's total assets for the purposes of making this representation, America Online shall exclude any cash and cash items (such as receivables), government securities and any assets acquired (through incuiring indebtedness or otherwise) for the purposes of causing America Online to not be characterized as an entity described in (i) or (ii) of the first sentence of this paragraph or causing America Online to meet the requirements of section 368(a)(2)(F)(ii) of the Code. 13. At the Effective Time, America Online will not be under the jurisdiction of a court in a"Title 11 or similar case." For purposes of the foregoing, a"Title 11 or similar case" means a case under title 11 of the United States Code or a receivership, foreclosure or similar preceding in a federal or state court. 14. The fair market value of the assets of America Online will exceed its liabilities. 15. To the knowledge of America Online, none of the compensation to be received by any stockholder-employees of America Online for services rendered prior to the Effective Time was or will be separate consideration for, or allocable to, any of their shares of America Online Common Stock; none of the Holdco Common Stock to be received in the Merger by any stockholder-employees of America Online will be separate consideration for, or allocable to, any employment, consulting or similar agreement with respect to services rendered prior to the Effective Time; and the compensation paid to any stockholder-employees of America Online for services rendered prior to the Effective Time was or will be for services actually rendered and was or will be based upon azms-lengih agreements. 1 b. America Online is not currently, and during the five years preceding the Effective Time will not have been, a"United States real property holding corporation." For purposes of the foregoing, a United States real property holding corporation means a corporation in which the fair mazket value of its United States real property interests equals or exceeds fifly percent of the fair market value of its (i) United States real property interests, (ii) its interests in real property located outside the United States, and (iii) any other of its assets which aze used or held for use in a trade or business. 17. As of the Effective Time, neither America Online nor any corporation related to America Online will own beneficially, or will have owned beneficially, during the five years preceding the Effective Time, any shares of stock of Time Warner or other securities, options, warrants or instruments giving the holder thereof the right to acquire stock of Time 003780-0007-00143-a018CJNIX-OTH Simpson Thacher & Bartlett -5- Cravath, Swaine & Moore [Date] Warner or other securities issued by Time Warner other than the stock option held by America Online pursuant to the stock option agreement attached to the Merger Agreement as Exhibit A. 18. The only capital stock of America Online issued and outstanding is America Online Common Stock.. 19. America Online will not take, and, to the best knowledge of the management of America Online, there is no plan or intention of any holders of America Online Common Stock to take, any position on any Federal, state or local income or franchise tax return, or to take any other tax reporting position, that is inconsistent with the treatment of the Merger as an exchange within the meaning of Section 351 of the Code and the regulations thereunder and as a reorganization within the meaning of Section 368(a) of the Code and the regulations thereunder. 20. The Merger Agreement, the documents described in the Merger Agreement, the Proxy Statement, and the Fonn S-4 represent the entire understanding between or among (i) Holdco and its subsidiaries, (ii) America Online and its subsidiaries and (iii) Time Warner and its subsidiaries and, to the best knowledge of the management of America Online, between or among such entities and the affiliates and stockholders of Holdco, Time Warner and America Online with respect to the Merger and there are no other written or oral agreements regarding the Merger other than those expressly referred to in the Merger Agreement, the Proxy Statement and the Form S-4. 21. The undersigned is authorized to make all the representations set forth herein on behalf of America Online. Very truly yours, America Online By: Title: 003780-0007-00143-AO1BCJbDC-OTH EXHIBIT 7.2(c)(3) [FpRM OF REPRESENTATION LETTER] [LETTERHEAD OF TIME WA.RNER] [Date] Re: The Merger of Time Warner Merger Sub with and into Time Warner Simpson Thacher & Bartlett 425 Lexington Avenue New York, New York 10017 Cravath, Swaine & Moore Worldwide Plaza 825 Eighth Avenue New York, New York 10019 Ladies and Gentlemen: In connection with the opinions to be delivered pursuant to the Agreement and Plan of Merger (the "Merger Agreement") dated as of January 10, 2000, between America Online, Inc. ("America Online"} and Time Warner Inc. ("Time Warner"), in which America Online Merger Sub ("Sub 1'�, a subsidiary of a newly organized Delawaze corporation ("Holdco"), shall be merged with and into America Online with America Online surviving as a wholly owned subsidiary of Holdco, and Time Warner Merger Sub ("Sub 2"), another subsidiary of Holdco, shall be merged with and into Time Warner with Time Warner surviving as a wholly owned subsidiary of Holdco, the undersigned certifies and represents on behalf of Time Warner, after due inquiry and investigation, as follows (any capitalized term used but not defined herein shall have the meaning given to such term in the Merger Agreement): 1. The facts relating to the contemplated merger (the "Merger") of Sub 2 with and into Time Warner pursuant to the Merger Agreement, as described in the Merger Agreement, and the documents described in the Merger Agreement, are, insofar as such facts pertain to Time Warner, true, correct and complete in all material respects. The Merger will be consummated in accordance with the Merger Agreement, and as described in the Proxy Statement and the Form S-4, and none of the material terms and conditions therein has been or will be waived or modified. The Merger is being effected for bona fide business reasons. 003790-OOD7-00143-AOIBCJMX-OTH Simpson Thacher & Bartlett -2- [Date] Cravath, Swaine & Moore 2. The fair market value of the Holdco Common Stock and cash in lieu of a fractional shaze of Holdco Common Stock received by each holder of Time Warner Common Stock in the Merger will be approximately equal to the fair market value of the Time Warner Common Stock surrendered by such holders in the Merger. The fair market value of Holdco Series LMCN-V Common Stock and cash in lieu of a fractional share of Holdco Series LMCN-V Common Stock received by each holder of Time Warner Series LMCN-V Common Stock in the Merger will be approximately equal to the fair market value of the Time Warner Series LMCN-V Common Stock surrendered by such holders in the Merger. The fair market value of Holdco Series LMC Common Stock and cash in lieu of a fractional share of Holdco Series LMCN-V Common Stock received by each holder of Time Warner Series LMC Common Stock in the Merger will be approximately equal to the fair market value of the Time Warner Series LMC Common Stock surrendered by such holders in the Merger. The fair market value of Holdco Series E Preferred Stock received by each holder of Time Warner Series E Preferred Stock in the Merger will be approximately equal to the fair market value of the Time Warner Series E Preferred Stock surrendered by such holders in the Merger. The fair market value of Holdco Series F Preferred Stock received by each holder of Time Warner Series F Preferred Stock in the Merger will be approximately equal to the fair mazket value of the Time Wamer Series F Preferred Stock surrendered by such holders in the Merger. The fair market value of Holdco Series I Preferred Stock received by each holder of Time Warner Series I Preferred Stock in the Merger will be approximately equal to the fair mazket value of the Time Warner Series I Preferred Stock surrendered by such holders in the Merger. The fair market value of Holdco Series J Preferred Stock received by each holder of Time Warner Series J Preferred Stock in the Merger will be approximately equal to the fair market value of the Time Warner Series J Preferred Stock surrendered by such holders in the Merger. The Holdco Common Stock, Holdco Series LMCN-V Common Stock, Holdco Series LMC Common Stock, Holdco Series E Preferred Stock, Holdco Series F Preferred Stock, Holdco Series I Preferred Stock and Holdco Series J Preferred Stock are referred to collectively herein as the "Holdco Capital Stock". The Time Warner Common Stock, Time Warner Series LMCN-V Common Stock, Time Warner Series LMC Common Stock, Time Wamer Series E Preferred Stock, Time Warner Series F Preferred Stock, Time Warner Series I Preferred Stock and Time Warner Series J Preferred Stock are referred to collectively herein as the "Time Warner Capital Stock". The Time Warner Merger Consideration to be received in the Merger by holders of Time Warner Capital Stock was determined by azm's length negotiations between the managements of America Online and Time Warner. In connection with the Merger, no holder of Time Warner Capital Stock will receive in exchange for Holdco Capital Stock, directly or indirectly, any consideration from Holdco or Sub 2 other than Holdco Capital Stock and cash in lieu of a fractional share thereof. 3. Time Warner, prior to and in connection with the Merger, has not redeemed any of its stock or made any distributions with respect to its stock. Additionally, prior to and in connection with the Merger, no corporation related to Time Warner has acquired Time Wamer's stock with consideration other than stock of either Time Warner or Holdco. For purposes of this representation letter, two corporations shall be treated as related to one another if immediately prior to or immediately after the Merger, (a) the corporations are members of the 003780-000"7-00143-A018CJNIX-OTH Simpson Thacher & Bartlett -3- [Date] Cravath, Swaine & Moore same affiliated group (within the meaning of section 1504 of the Internal Revenue Code of 1986, as amended (the "Code"), but determined without regard to the exclusions of section 1504(b) of the Code) or (b) one corporation owns 50% or more of the total combined voting power of all classes of stock of the other corporation that are entitled to vote or 50% or more of the total value of shares of all classes of stock of the other corporation (applying the attribution rules of section 318 of the Code as modified pursuant to section 304(c)(3)(B) of the Code). For purposes of this representation, a corporation that is a parh�er in a partnership will be treated as owning or acquiring any stock owned or acquired, as the case may be, by the partnership and as having furnished its share of any consideration ftunished by the partriership to acquire the stock, in each case, in accordance with its interest in the partnership. 4. To the best knowledge of the management of Time Warner, there is no plan or intention on the part of holders of Time Warner Capital Stock to sell, exchange or otherwise transfer ownership (including by derivative transactions such as an equity swap which would have the economic effect of a transfer of ownership) to Holdco, Time Warner or any person related to Holdco or Time Warner, directly or indirectly (including through partnerships or through third parties in connection with a plan to so transfer ownership), of any shares of Holdco Capital Stock (other than fractional shares of Holdco Capital Stock for which holders of Holdco Capital Stock receive cash in the Merger). 5. Following the Effective Time of the Merger, Time Warner will hold at least 90% of the fair market value of the net assets and at least 70% of the fair market value of the gross assets held by Time Wazner immediately prior to the Merger. For purposes of this representation, amounts paid by Time Warner or Sub 2 to dissenting stockholders of Time Warner, amounts used by Time Warner and Sub 2 to pay reorganization expenses and all redemptions and distributions (except for regular, normal dividends) made by Time Warner will be considered assets held by Time Warner or Sub 2, as the case may be, immediately prior to the Merger. Any dispositions of assets held by Time Warner prior to the Merger which are made in contemplation of, or as part of, the Merger will be for fair market value, and the proceeds thereof will be retained by Time Warner. 6. At the Effective Time of the Merger, Time Warner will be conducting Time Warner's historic business or using a significant portion of Time Warner's historic business assets in a business. 7. Pursuant to the Merger, at least (i) 80% of the total combined voting power of all classes of Time Wamer stock entitled to vote and (ii) 80% of the total number of shares of each other class of stock of Time Warner will be exchanged solely for the Time Warner Merger Consideration. For purposes of this representation, shares of Time Warner Capital Stock exchanged for cash or other property originating with Holdco or Sub 2 will be treated as outstanding Holdco Capital Stock at the Effective Time. 003780-0007-00143-AOIBCJNDC-OTH Si:..�,son Thacher & Bartlett -4- [Date] Cravath, Swaine & Moore 8. At the Effective Time, Time Warner will not have any warrants, options, convertible securities or any other type of right pursuant to which any person could acquire any stock of Time Warner which, if exercised or converted, would affect Holdco's ability to acquire or retain control of Time Warner. For purposes of this representation letter, "control" with respect to a corporation shall mean ownership of at least (i) 80% of the total combined voting power of all classes of stock entitled to vote and (ii) 80% of the total number of shares of each other class of stock of the corporation. 9. Prior to the Effective Time, Time Warner has no plan or intention to issue any additional shares of stock that would cause Holdco to own less thar. (i) 80% of the total combined voting power of all classes of Time Wamer stock entitled to vote or (ii) 80% of the total number of shares of each other class of stock of Time Wamer. 10. Holdco, Sub 2, Time Warner and the stockholders of Time Warner will pay their respective expenses, if any, incurred in connection with or as part of the Merger, except that expenses incurred in connection with the filing, printing and mailing of the Joint Proxy Statement/Prospectus and Form S-4 will be shared equally by America Online and Time Warner. Time Warner has not agreed to assume, nor will it directly or indirectly assume, any expense or other liability, whether fixed or contingent, of any holder of Time Warner Capital Stock in connection with or as part of the Merger or any related transactions. Notwithstanding the foregoing, all liability for transfer taxes incurred by a holder of Time Warner Capital Stock will be paid by Time Wamer or stockholders of Time Warner, and in no event by Holdco. 1 l. There is no intercorporate indebtedness existing between Holdco or its subsidiaries and Time Wamer or its subsidiazies that was issued, acquffed or will be settled at a discount. 12. Time Warner will not (i) elect, or have in effect an election, to be treated as a"regulated investment company" or as a"real estate investment trust" or file any tax return consistent with such treatment or (ii) be a corporation 50% or more of the fair market value of whose total assets are stock or securities and 80% or more of the fair mazket value of whose total assets aze assets held for investment. In making the determinations described in (ii) above, (x) the stock and securities of any subsidiary of Time Wamer shall be disregarded and Time Warner shall be deemed to own its ratable share of such subsidiary's assets and (y) a corporation shall be considered to be a subsidiary of Time Warner, if Time Wamer owns 50% or more of the combined voting power of all classes of the stock of such subsidiary that are entitled to vote, or 50% or more of the total value of all of the outstanding stock of such subsidiary. In addition, in determining the fair market value of Time Warner's total assets for the purposes of making this representation, Time Warner shall exclude any cash and cash items (such as receivables), government securities and any assets acquired (through incurring indebtedness or otherwise) for the purposes of causing Time Warner to not be characterized as an entity described in (i) or (ii) of the first sentence of this paragraph or causing Time Wamer to meet the requirements of section 368(a)(2)(F)(ii) of the Code. 00 37 8 0-0007-0014 3-A018 C,TNDC-OTH Simpson Thacher & Bartlett -5- [Date] Cravath, Swaine & Moore 13. At the Effective Time, Time Warner will not be under the jurisdiction of a court in a"Title 11 or similar case." For purposes of the foregoing, a"Title 11 or similar case" means a case under title 11 of the United States Code or a receivership, foreclosure or similar preceding in a federal or state court. 14. The fair market value of the assets of Time Wamer will exceed its liabilities. 15. To the lrnowledge of Time Warner, none of the compensation to be. received by any stockholder-employees of Time Warner for services rendered prior to the Effective Time was or will be separate consideration for, or allocable to, any of their shares of Time Warner Capital Stock; none of the Holdco Capital Stock to be received in the Merger by any stockholder-employees of Time Warner will be separate consideration for, or allocable to, any employment, consulting or similar agreement with respect to services rendered prior to the Effective Time; and the compensation paid to any stockholder-employees of Time Warner for services rendered prior to the Effective Time was or will be for services actually rendered and was or will be based upon arms-length agreements. 16. Time Warner is not currently, and during the five years preceding the Effective Time will not have been, a"United States real property holding corporation." For purposes of the foregoing, a United States real properiy holding corporation means a corporation in which the fair market value of its United States real property interests equals or exceeds fifly percent of the fair mazket value of its (i) United States real property interests, (ii) its interests in real property located outside the United States, and (iii) any other of its assets which aze used or held for use in a trade or business. 17. The only capital stock of Time Wamer issued and outstanding is Time Warner Capital Stock. 18. As of the Effective Time, neither Time Warner nor any corporation related to Time Warner will own beneficially, or will have owned beneficially, during the five years preceding the Effective Tune, any shares of stock of America Online or other securities, options, warrants or instruments giving the holder thereof the right to acquire stock of America Online or other securities issued by America Online other than the stock option held by Time Warner pursuant to the stock option agreement attached to the Merger Agreement as Exhibit A. 19. Time Wazner will not take, and, to the best laiowledge of the management of Time Warner, there is no plan or intention of any holders of Time Warner Capital Stock to take, any position on any Federal, state or local income or franchise tax return, or to take any other tax reporting position, that is inconsistent with the treatment of the Merger as an exchange within the meaning of Section 351 of the Code and the regulations promulgated thereunder and 003780-0007-00193-AO18C.Tt9C-OTH Simpson Thacher & Bartlett -6- Cravath, Swaine & Moore as a reorganization within the meaning of Section 368(a) of the Code and the regulations promulgated thereunder. [Date] 20. The Merger Agreement, t�ie documents described in the Merger Agreement, the Proxy Statement, and the Form S-4 represent the entire understanding between or among (i) Holdco and its subsidiaries, (ii) Time Warner and its subsidiaries and (iii) America Online and its subsidiaries and, to the best knowledge of the management of Time Warner, between or among such entities and the affiliates and stockholders of Holdco, America Online and Time Warner with respect to the Merger and there are no other written or oral agreements regazding the Merger other than those expressly referred to in the Merger Agreement, the Proxy Statement and the Form S-4. 21. The undersigned is authorized to make all the representations set forth herein on behalf of Time Warner. Very truly yours, Time Warner By: Title: 003780-0007-00143-AOIBCJNDC-OTH EXHIBIT 3 As explained in Exhibit 2, the entity that currently holds the franchise and operates the cable system in your community will continue to do so notwithstanding this transaction. Moreover, the transaction will have no adverse consequences on the current terms and conditions of service and operation of the system. EXHIBIT 4 As explained in Exhibit 2, the pending transaction will not change the legal entity which operates the cable system in your community, and hence such entity will continue to be duly qualified to transact business in the state or other jurisdiction in which the system operates. EXHIBIT 5 Transferee will not commence business operations until consummation of the proposed transaction, and thus has never had an application for a cable franchise transfer or renewal dismissed or denied by any franchise authority. To the extent the question seeks such information as to an affiliated entity, any af�iliate of either Time Warner Inc. or American Online Inc., the answer to question 4 is no, except as set forth below. We are aware of no instance in which an application by Time Warner Cable or its affiliates for renewal of a cable television franchise has been finally denied. Described below are the only instances, to the best of our knowledge, where applications for consent to transfer a franchise have been denied: (1) In early 1995, the City of Ithaca, New York deternuned to "withhold its authorization and consent" to a cable television transfer from Time Warner Entertainment Company, L.P. ("TWE") to an affiliated entity, Time Warner Entertainment - Advance/Newhouse Partnership, until certain issues in dispute between the TWE and the City are resolved. (2) In early 1995, the City of Winter Springs, Florida voted not to approve the application for consent to transfer of a franchise from TWE to Time Warner Entertainment - Advance/Newhouse Partnership. In each situation described above, TWE continues to hold the franchise and operate the system pending receipt of authorization to transfer the franchise to TWE's affiliate, Time Warner Entertainment - Advance/Newhouse Partnership. EXHIBIT 6 Time Warner Inc. holds direct and indirect partnership interests in Time Warner Entertainment Company, L.P. ("TWE"). In Connie Haschmann v. Time Warner Entertainment Compan ,y L.P., U.S.D.C. E.D. Wisconsin, Case No. 97-3333, 97-3708, a jury found that TWE had violated the Americans With Disabilities Act ("ADA") and the Family Medical Leave Act ("FMLA") by failing to provide the plaintiff both with FMLA leave and reasonable accommodation under the ADA. I�` : i : �I ITi7 There are no documents, instruments, agreements or understandings for the pledge of stock of the transferee as security for loans or contractual performance. EXHIBIT 8 Attached are the most recent SEC Form 10-K and SEC Form 10-Q, as submitted to the Securities and Exchange Commission by each of Time Warner Inc. and America Online, Inc., as well as the respective Annual Reports of each company. 1 � � <-1 - ._. �� .. � � �= _ _ - �{ '�' � "f ..r� - -# � c � �."i - - - . , W - _ - � �=f n . __ _ _ a ,-�•�, .�,�•..�� r � �,,•_ : - _ _ r � � ' ` y � � ' - � �.:, �'^' ; `� � ..c. : � J-..��- Y';t t _ J� �,� ;� y�s-� � ��rX�. - " ' ' -/ S.-� .�• _ � jh . _ ; - : �.' �;,..�. C'�- 3`'�� i. t. ' .s �T �?':.�'7t �.,, . ,. �� ':'. �� _ -eT"' -_?' ._. _._. _i� __ . .. 1 - � r >. � j� _ ' a . - � �, A ' - = `: . -� � . _ �; i; . . t:� _=1rL ' !�;^,,. ` y.� '=�` � ' - �� - . .. :. lU �u� �har��s��e��o - Stevc Casc .� .� .� :� � .� .� � � � '� � '� � � �F' � �5 ,� Cha:-r•:.r. c:,��' ChiejErrCl1(t.. ��..�• "fhe inceraccive medium has already chaii�<l aur lives in remari:able ways, and ic �vill l�ccome even morc cenu•al to pcoplc and businesses arouild chc �vodd �vidi thc dx�vit of ;hc new millennium. Ac AOL w� are helpina w Icad che way — as �ve have for che las� 1� y�:us. l�he in�eraccive experience is becominb incrcasingly embedded in consumers' everyday ,o;,c�nes — everythiug from communic.icin�, shopping, and keeping informed to invesci,i�> learning and jus� l�aving fun. And nearly every coaipan�� already has, or �vill, puc ics business unline — seekina the Uenefi�s of che incdiiim's efficiencies, convenience ai�d r�ach. Amcrica Online is Ieading this interactive revolucion wich our mulciple brands. From the i,;ccminent mus-marke� inceraai�'c bi�and — our flagship AOL service — co Ne�scape, Con�puServe, ICQ, Diaical Ciry 1nd Mo��icFone, wc are abl� to carbet a wicle range of oppor�unicia. And to ,uppor� all the.�e brands, �ve have buil� a cosc-efficienc, shared inEras�ructure. ��:�c believe the success of our Compauy grows Froni our direcc and focused relationships wich our cuscomers — both members and paruters. t1s our members' sa�isfaction and retention boch reached all-time higlis this past year, we are confidenc this focus on consumers �+�ill ciri�•c our con�inued leadership of che Internec iiidustry. 'I�hc Company's reeord financial and operational performance across our brands, as µ�eU as c}ic steps we took �o broaden and dee�en our capabilities, have generated tremendous n�omennim for the-coming year. In shorc, �+'e are pleased to say that America Online has nc�•cr been scronger. Our fiscal 1999 hightiahcs included: � Revenucs rr•�:i::.'. 5�� ` h�!Gon, a 55% increase over thc previous fiscal year. Advertising, commerce and other revenucs climf�ed A4°,�• t�� S i tu!! ��:�. ��'��I� a backlog of commitced revenues of $1.5 billion.l'he operating marain, beEore special charocs, rcach�.i 1G •�^.� in chc (ourch quarcer. ► AOIs memh:::h��• r.c:�� f�um 12.5 million co 17.6 million during fiscal 1999.Together wich CompuServe, paying members co�aled nearl�• ?:� rn�li�oa. �:�_�udin�, more chan 3 million combined AOL and CompuServe memben oucside the U.S. Regiscra�ics o: o:�� k*t�:.l brands rounded out our multi-brand scrategy wich ICQ(38 million), Necscape I�etcencer (17 million) a,�' :iC!L lns:.mc Mcsscnaer (25 million). ► America O::I�r.� :��cr �r:1 ��•ieh Necscape Communica�ions> and joined forces wich Sun Microsyscems co create the Sun- Netscape Alii-�i;c, u� dc�'�Ic,p comprehensive e-commerce solutions for companies seeking to join the Nec Economy. � We introd�::rd :�nl• <<ti r�ustralia, and prepared for AOL lauriches in Latin Amcrica and Hong Kong in FY 'These achie�•cn:�n«-aric'. many more—strengthened our Company and kepc up our momencum. More imporcandy, thc�• h:IE�rd us build on our core strcng�}is: • The mose po�•:rr�ul collc:cion of inceractive braJids • The largest base of paying customers in cyberspace • Th: scron�:sc finaeicial posicion in our history> suscuned by mul�iple revenue screams • Alliances alr�ad�• in placc co deliver services nacionwide over broadband connectiviry and ocher devices • Induscr�•-Icadina eechnological expercise that makes interacnviry simple and accessible for consumers • Scron� incernacional joinc vencure parcners • L.eadership focus on key public poliry issues • A nimble and quick management team • A world-class orb nization of more than 12;000 expericnced employces. 'I'aken togecher, �hese streng�hs posicion us to continue co deliver on our miuion and co Iead our industry inco the exci�ing fucure of inceraccive services. Toc�y, �ve are seeing the nexc wave of Incernec growch on che horizon. Interacciviry is fasc moving beyond PCs cechered co narrowband telephone lines. Consumers will have the abiliry to conneec anytime from anywhere, as well as enjoy robusc new high-speed online services, from interaccive TV and handheld devices to broadband aceas. Bob Pittman Preside�tt and Giief Operating OJhcer surpasses 20 million regtstrants conneaea �o nv,. accv�wa,a �� ,...n..� ...... -- Internet users in the AOURoper Starch Cybcrscudy wich che Cisneros Group ;,�.-: -:.=:: ;�; :- :. �.: _ j�` Yy r..? �.�_:_'?;r.>>: .�e.,f � % and Meg Ryan s in You've Got M� �;�\Ve have formed alliancr� wirh �3eli Atlantic, S13C; C:ocnnwnicziians, Amcri�ech ai:d G"!'E co y�nake oiu hiah-speed !1C)?: 1'lus serviee a��ailablc ro our membcix chrou,;h cheir DSL �;�3 conncccivity: "Iogc�hcr, thosc companic� covcr CS% af all U.S. houscholds. Contribucin� to our � ' hroadb:tnd ��pestry u our s�ra�cg�e alliance �vi�h Hii�hes Flectronicc 7'hrouph Hu�hes' Direcl'C: c�tellice syscem, �ve will be able to offer broadband access to t10L. membcrs na�iomvide. 3 ,� .. � Third, doiiig busii�ess and shopping onlit�c will become even more e�cient and � convenient as e-comcuerce reac�ies the next level of success. � � a � s � t A � � � � � I � � k � i � � � E�•en as our Compan}' tet lnrerne� reeords for ad.�ercisin ;1nd commcrce revenucs and for the total � sales of �oods and service�, ��-c continued ro make ic easicr for business.s to no onlin� and .� eonsumers to make Inrernec purcliases. � During fiscal 1999, w-e signed 58 mul�i-y�ar ad��ercising and commerce agreements, each worth in cxcess of �1 tnillion. 1n the Interne�'s largac ever ad��ercisin� and marke�inD parenership, we reached a five-year agree.�ncnt worch up ro SS00 million wich First USA. � I�esigned to enliance the shoppinn experience across aur brancis, our ShopC�AOL iniciacive is set�ing a new induscry srandard for consumer conveniciice. ShopC�AOL provides s�acnless , incearacion to our commerce partners' sites and ne�� t/eb-based tools to help them promore their products even n�ore effeuively on che service. In the comin� year, we will also incroduce � ShopC�Nc�scapc and ShopC�CoinpuServc. "rhe Sun-T�ecscape Alliancc has incroduced "iPlane�" as ics new produa brand For ics .'.�` comprehensive, easy-to-deploy Internec inFrasuucuire and e-commerce solutions. By fiscal year's end, more chan 300 companies, indudinK over halEof che Forcune 100, curned to che Alliancc ,� to lielp puc their businesses online. Fourth, Internet use worldwide will explode with the increasing availability of �� connected devices. .'= Our mulciple-brand straccay hu strongly posicioned us �o sake advancage of ncw opporcunities around the �vorld, as well as supporc our long-terni global growch and leadership. � Over the pasc year, AOL Internacional (including AOL and CompuServe) topped 3 million members oucside �he US, just 2-1/2 years after the first AOL International service tivas founded in �� Germany. Our strongc�c in�ernarional brand, ICQ, concinued iec rapid overseas growch — wich nexrly nvo-thircls of its 3S million registcancs based oucside �he US. In acldicion, Necsc�pe ; z] Neccencer also boascs a significanc in�ernational audience. We are pleased wich the momentum rhis pasc year in our AOL Japan service, and our new Australian service is making inroads in�o thac market. With the Cisneros Group, AOL Latin America is gearing up to launch localized AOL services in Brazil, Mexico and Argencina. We also made a scrategic investnient in China.com to strengthen our role in the AOL Hong Kong service to be launched in che coming year. In Europe, we excended our leadership as thc la�gest pan-European Incernet service wich our AOL and CompuServe bra�ids. In one new iniciative, we are employing our mulciplc-bra�id straiegy to launch Necscape Online, a new Internet service, For the emerging "subscripuon-free" value markec in the UK, �vhere regula�ions allow 1SPs co fund their basic operations wich a share of local celephone tolls. .] Finally, ac the medium becomes more central to People's lives, it will become increasingly critieal that we build public uvst and ensure that the medium serves the public interest �� We are continuing to cake the lead on che fu[l range of public poliry and social issues .� surrounding the growch of che Incernec boch in the Uniced Scaces and abroad. Many of che poliry issua are ulcimacely cencered on creacing a beccer environment for online � consumers. Safeguarding children, procectina privary, enforcing securiry and ensuring fair cax crea�menc of online purchues are just some of che issues on �vhich America On(ine has led � � forge che In�ernec's largest ad�•ertising partncrship — � 5 years, up to $500 million � exceeds 16 million s r �� a 30 ► and� launcha scracegic alliance r- calendaring service million wich Sun Microsystems acquired b}� AOL reaiscrants 1� � ��r �9 . . � Boarcl of Dircctors � ' Amcricl (.inline, Inc $;cphcn M. Guc � � C�hairman af �he $oard Sc ChirF�reeucive O�cer, � Amcrica Or�linc, Inc. Danicl F. Al:ctson C:hairman of thr Board, :� I�c�rcl Cammunications Inc. Cv-Chair�ttan, _ � . F.agle Ri�•er, L.L.C. " James I.. liarl'sciale Partner, i� Rark.cl:�e Group Frank J. Cauficld � Partner, Kleitier I'c�kins Caureld & $ycrs ; t� General Alexander M. Haig, Jr. Chairman & President, �Vorldwide Associa�es, Inc. � �lliun N. Mdton C.liairman & Chief Execucive OEficer, : � CyberCash, Inc. Dr. Thomas Middelhoff Chainnan & Chief Exeauive Officer, Bertdsmxnn AG Robert W. Piitman Presidcnt & ChieFOperatino OFficer, Anierica Online, Inc. Gcncral Colin L. IPOwdI USA(Rcc) Franklin D. Raina Chairman 8C Chicf Executive OfEicer, F.tnnic Mae Shareholdcr Information Ameria Online,lnc Scnior Corporatc Exccucivcc Stevc Case Chaircnan C ChicEExccucive Officer Bob Pittman Prtsidcnt cS; ChieE Opera�in ; O,`fiecr Kc» Novack Vice Chairman Bill Raduchel ChicfTech��olo;y Officcr Kathy Bushkin Senior Vice Presidcnc £�c Chief Communica;ions OFficcr Paul Cappuccio Senior Vice Pre>idenc & Gencral Counscl Sheiia Cl:uk • Scnior Vice Presidenc, Leaal cC' Corporare Secreiary Miles Gilburne Senior \�ice Presidenc, Corpora�e Devclopmenc M;ke I�clly Senior Vice Presiden� & ChieEFinancixl Officer I.en Leadcr Prcciden�, Im•estmrn�s Jim MacGaidwin Senior Vice Presiden�, Controller, Chicf Accouncin� L� IIudge�ing Officcr Ray Murphy Senior Vice Praidenc &'!'reasurer George Vradenburg, III Sertior Vice Presidenc for Globxl and Strar Dic Policy Form 10.K Copies of �he Company's Annual Reporc on Form l0-K for che �tirr cnded Junc 30, 1999 (excluding oel�ibits hercto) are available without char�e, upon requese co chrCorponte Seerccary. Americi Online, Inc., 22000 AOL Way. Dulla, VA 201G(. ��Amcrin Online, lne Web Si�e For more informadon on che Company, pinsc visic ia Web Sire at www.aol.cortJcorp. : � Forward-Lovking Sratanma Ple+u refet to the seaion encicled 'Forward-Looking $necments under hlanagemenci Uiseussion and Analysis of Fnaneial Condicion and Raulu of Openrions on }'wm 10.K for `� the ywr ended June 30, 1999, which a«ompanics and is parc of ehis Annual Aeporc, for a discussion rdued m forward-looking sntemrnu conrained in chis Annu�l f.eporc. � � Corpontc Hndquar[us 22000 AOL Way D..11� va �eiFr. Tndemark Information Amerin Online, AOL, AOLnec, Buddy Lin, and the com�ny's triangle logo arc tegiseered cndemarkt oEAmeria Online, Ine AOLCOM, AOLNc�Mail, ICQ lnsnne Mcssengcr, D�g�cal Gry. AOL Insclnc Messcnger, AOL NnFnd, Inscanc Messsge, and Parrnn! Concro�, ace crrdemarks of Ameriea Online, lne Tlasepe is a registercd tndemark of Netsopc Communiacions Corporrcion, a subsidiary of Amerie OnGae, Ine CO^�P�� u� Rg�erod tndemuk of CompuServe Ineeraaive $ervices. Inc., a subsidiary of America Onlinq Ine Ceruin o�her names and logos c}uc ue procared by cndrnurl: appar throughouc ehis rcporc. Racha r}un lisi che namc and enucia chac own chose crademar►s or inserc a nademark rymbol wich each mencion oF�he name procececd by eadem�rl:..�lmeria Onlinc. Ine, spces ihac it u using ehe names only for edicorial pucposes and eo �he brnefic of chc cndemark owner wich no incrncion of infringing upon thac crademad:. Scnior Operatin� Exccutivcs B:irry Aril:o Senior Vice President, I�ecscape l:ncecprisr Gro Mycr I3crlo�v Pr�idcn�, Li�craccivc Marke�in� Ann Brxc%bill Scr.ior Vice Presiden�, Communic�cionc Jan 13randc Presidenc, Alarkccin� M:itshall Cohen Senior Vice I'residenc, $rand De��elopmenr David Colbucn Presidenc, liusincss Afisirs Jack Dav;es Presidenc, Intcrnarional llonn Davis ChieFOp.ratin� Of�icer, Interactive Properties G Ted Leonsis I'residcn�, In�eraccive Properties Group Jim Martin Senior Vice Presidenc S: General Manaaer, Net: Ray Oolethorpc Pru�dcnt, Technolooies Jonathan Sacls Scnior Vice Presidenc & General Manager, AOL Scrvice Steve Savignano Senior Vice Presidenc, Netscape Enterprise Gro� Barry Schuler Praidcnc, Interaccive Services Group Mark Stavish Senior Vice President, Human Resources Mayro Stunu, Jr. Chief Operating Officer, Incenccive Serviczs Gro Audrry Wul Senior Vice Prrsidenc & GtnerAl Manager, CompuScrva Servicc 'Tcansfer Agmc and Itep,i:tnr l3ankB�ton, NA do EquiScrvc P.O. Bon 8040 Boscon, MA 022GCrSO40 lnvcstor Rdacions Numbcr: (781)575-3400 Intemet Addraz: http:/hvww.equiservacom Marl:et Pcice of Common Stxk The followine tablc seu Forch chc rrnoc of high and low sale prica for che ComEwny's Common Sroek fur ehe periods ind'�ted and eefleecc all srock splics efFeeced by the Compar Eor the pnarc�r rndeci• Hieh Low Sepcember 30. 1�97 E I O.OG E 7.00 Lkcember 31, 19�7 S 11.41 S 5.00 ivLirch 31, 1998 S 17.47 S 103t )une30, 1998 g 27.41 S 173t Sepcember 30, 19�8 S 35.13 S 17.50 December 31, 1995 E 80.00 S 20.66 March 31, 1999 E 153.75 S 67.00 Junc 30, 1999 $ 175.00 S 89.50 Thc Company hss nevcr declarcd, nor has it paid, any cash dividends on ia Common Scoek. The Company eurrencly incends co renin its earnings to 6nanec futurc growch and, therefocr, does noc antidpate paqing casl� dividends on ics Common Stod: in chc foraeeble fucurc As ofAugust 11, 1999, che approxima�e number of stoekholdea of record of Common S�oelc was 25,006. This does noc indude che number of persons whose stock is in nam� nce or 'xrcec rumc accouns through brokers. F�cchangc InFormation The Companyi Common $tocl: is cnded on che Nav York Stocic Fxchangc under �hc symbol AOL" Opcions on ihe Companyz scxk arc cndcd on chc Chingo Board of Opcions Exchang ehe Amerinn Seod; Exchange, and the 1'acific Scock Fxchange. Indepcndent Auditors Legal Counsel Ernsc & Young LLP Minc� lcvin, Cohn, Fcrris, Glovslry and Popco. P. Vicnna, VA Boston, MA FU1L�1 10-(2 SECURITIES A1�-D EXCHANGE CONIMISSION `Vashinaton, D.C. 20549 . (Mark One) [X] Quarterly Report under Section 13 or 15(d) of the Securities Exchange Act of 1934 For the quarterly period ended: September 30, 1999 �• [] Transition report pursuant to section 13 or 15(d) of the Securities Exchanae Act of 1934 For the transition period from to Commission File Number: 001-12143 America Online, Inc. (Exact name of reo strant as specified in its charter) I}ela�vare (State or other jurisdiction of incorporation or organization) 54-1322110 (I.R.S. Employer ldentification No.) 22000 AOL �Va�•, Dulles. �'irainia 20166-9323 (Address of principal execurive offices and zip code) RegistranYs telephone number, including area code: (703) 265-1000 Former name, former address, and former year, if chan�ed since last report: Not applicable Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filina requirements for the past 90 days. Yes X No Indicate the number of shares outstanding of each of the Issuer's classes of Common Stock, as of the latest practicable date. Title of each class Common stock $.O1 par value Shares outstanding on October 15,1999 .............................................................................1,117,743,377 PART I. 1 Item 1. Item 2. Item 3. PART II. Item 6. Signatures AMERICA ONLI\'E, INC. IlvDEX FINANCIAL Il\'FORMATION Condensed Consolidated Financial Statements Condensed Consolidated Balance Sheets — September 30, 1999 and June 30, 1999 Condensed Consolidated Statements of Operations — Three months ended September 30, 1999 and 1998 Condensed Consolidated Statements of Cash Flows — Three months ended September 30, 1999 and 1998 Condensed Consolidated Statement of Changes in Stockholders' Equity — Three months ended September 30, 1999 Notes to Condensed Consolidated Financial Statements Management's Discussion and Analysis of Financial Condition and Results of Operations Quantitative and Qualitative Disclosures About Market Risk OTHER INFOR�vIATION Exhibits 2 Page cj � 5 . 10 16 17 17 18 AMERICA ONLII�'E, INC. CONDENSED CONSOLIDATED BALANCE SHEETS (Amounts in millions, except share data) ASSETS C�xrrent assets: Cash and cash eguivalents ........................................................... Short-term investments .............................................................. =rade accounts receivable, less allowances of 555 and $54, respectively ............. Other receivables ................................................................... 2repaid expenses and other current assets ........................................... =ota1 current assets ................................................................ ?roperty and equipment at cost, net .............................•••........_....-••- other assets: =avestments including available-for-sale securities ................................. Product developmeat costs, net .....................•••-•••••........................ Goodwill and othez intangible assets, net ........................................... Other assets and deferred income taxes .............................................. LIABILITIES AND STOCKHOLDERS' EQUZTY Current liabilities: Trade accounts payable ........................................•••••................. Other accrued expeases and liabilities .............................................. �eferred revenue ...................•••-•••.......................................... =.ccrued persoanel costs ....:........................................................ Deferred netwozk services credit .................................................... Total current liabilities ........................................................... Long-term liabilities: *7otes payable .................................•••••-••••....-••...•••..._........... Deferred reveaue ...............................................•••.................. Otherliabilities ................................................................... Deferred network sezvices credit .................................................... Totalliabilities.........•--• ...................................................... Stockholders' equity: Preferred stock, S.O1 par value; 5,000,000 shares authorized, no shares issued or outs:anding at Septembez 30 and June 30, 1999 .................................. Coacaon stock, S-01 par value; 1,800,000,000 shares authorized, 1,116,859,792 aad 1,100,893,933 shares issued and outstanding at Septembe: 30 and June 30, 1999, respectively ..................................... Additioaal paid-in capital .........................................••••••-•-........ Accumulated other compreheasive incane - uarealized gaia oa available-for-sale securiCies, net ................................................ Retaiaed earnings ................................................................... Total stockholders' eguity .......................................................... See accompanying notes. Fi September 30, June 30, 1999 1999 ------------- -------- (Unaudited) $1,330 S 8a7 429 537 346 323 122 79 181 153 ------------ --------- 2,408 1,979 744 657 2,760 110 422 SS $6,502 $ 88 941 711 195 76 2,011 2,151 100 454 7 $5,348 $ �4 795 646 134 76 1,725 341 348 111 30 12 15 178 197 ------------ --------- 2,653 2,315 11 11 3,079 2.�03 424 168 335 151 ------------ --------- 3,849 3,033 ------------ --------- 56,502 55,348 AMERICA ONLINE, INC. CONDENSED CONSOLIDATED STATEMEN: ��F C)PERATIONS (Amounts in millions, exSept per share data) ([Jnaudited) Revenues: Subscription services ..........................:.......................... Advertising, commerce and other ........................................... Enterprise solutions.••••-•• .............................................. Total revenues ...............................................••••••....... Costs and exnenses: Cost of reveaues ........................................................•- Salesand marketing ..................••••...................•--........... Product development......••••• ....................................••••.... General aad administrative ................................................ Amortization of goodwill and oLher intangible assets ...................... Total costs and expenses ..............••••................................ Three months ended September 30, 1999 1998 -------- -------- $ 995 350 122 1,467 791 209 67 117 18 1,202 $ 723 175 101 999 583 174 67 82 16 922 Income from operations..• -•• ..............................•.•••.......... 265 77 Other iacome, net ......................................................... 37 5 -------- -------- Income before provision for income taxes .................................. 302 82 Provision for income taxes ................ (118) (6) ...._...•••••.....-••••._....... -------- -------- Net income ........................•••••••....................••••......... $ 184 $ 76 -------- -------- -------- -------- Earnings per share: Earnings pez share-diluted ................................................ S 0.14 S o.06 Earaings per share-basic .................................................. S 0.17 S 0.08 Weighted avezage shares outstanding-diluted ............................... 1,287 1,199 Weighted average shares outstanding-basic ................................. 1,110 997 See accompanying notes. 4 AMERICA ONL,INE, INC. CO:�'DENSED CONSOLIDATED STATENIENTS OF CASH FLOWS (Amounts in millions) (Unaudited) Three months ended September 30, 1999 1998 Cash flows from operating activities: Netincome ........................•••••............................................... S Adjustments to reconcile net income to net cash provided by operating activities: Non-cash restructuring charges.....••• ................................................. Amortization of deferred network services credit ....................................... Depreciation and amortization.....•-...•-•-••---••••••-•••••••••••••••••••••••••••••••• Compensatory stock options ............................................................. Deferred income taxes .................................................................. Changes in assets aad liabilities, net of the effects of acquisitions and dispositions: Trade accounts receivable ............................................................ (24) Otherreceivables .................................................................... (43) Prepaid expenses and other curreat assets ............................................ (27) Otherassets ......................................................................... (52) Investments including available-for-sale securities .................................. (99) Accrued expenses and other current liabilities ....................................... 204 Deferred revenue and other liabilities ............................................... 147 288 184 $ 76 2 (19) 79 3 117 Total adjustments ...................................................................... Net cash provided by operating activities .............................................. Cash flows from investing activities: Purchase of property and ewipment ..................................................... Product development costs .............................................................. Proceeds fran sale of investmeats ...................................................... Purchase of investments, including available-for-sale securities ....................... Proceeds of short-term investments, net ................................................ Other investing activities ............................................................. Net cash used in iavesting activities .................................................. Cash flows from financing activities: Proceeds from issuance of common stock, net ........................................... Principal aad accrued interest paymeats on line of credit and debt ..................... Proceeds from line of credit and issuaace of debt ...................................... Net cash provided by financing activities .............................................. Net increase in cash aad cash equivaleats .............................................. Cash aad cash equivalents at beginaiag of period ....................................... Cash and cash equivaleats at ead o� period ............................................. (19) 67 3 6 (43) (44) (9) 4 4 30 45 44 ------- ------- 472 120 (134) (18) (94) 108 15 (123) 97 (3) 94 443 887 $1, 330 (63) (lo) 14 (82) 89 (13) (65) 602 (1) 1 602 657 677 $1,334 Supplemeatal cash flow infozmation Cash paid during the period for: Interest..................................................................••••••....... $ 2 S 5 See accompanying notes. 5 � E� ., a a � � W Q � � � t.% Q H � � � � r � � W � L ZZ y w � V � � J � � � � � y � � � � � a W O � �W �] W E.y •y Q � .i�i O W � � � Q� A �..� � 0 � z 0 c w � � V Q Z O U L � 0 � F � � � � C C � .� .,� � 'C C � t� i+ � v � � a m � � v � L � L }� [ z 1 �°'" '; E Q f.�i O � � a[' u ' � Q V ~ i .i ' e H � � O � y � y .d p, � b a u i 4 � L � � C � � E � � u ' a , L � y C O i E � E � m � o i y U � N � � rt � � r � � y � , ; � r� r r� �.� m c � a� u r"� � ri 'i m � C II O C� .-1 rl � m II � . �� m � M II � vr n � u u � u � n ' n � n .a � � � � r c �n u N o� � en u � .i � e� u � i 11 � II u � u u � u n � 11 �� n m � � ��Q�� O 111 � N I� ri N i d' II I� � � N II � u n � u � n ri c� � r� m � � o� u o m ui .-i � r u �` r+ � � o u i N � Pf II � n � K II � u � n i II ri i i � � � � 'i 11 r+ � � u � n N � V► 11 � �� 11 t'1 01 i r O i � ; N II r1 rn �o rn u o� o� m t� u � II n c� r rn n a o �n � in u �o rn m n , u o vi � �o n o ,� � .-i u � � � u ; _„ � � �� : : ::::� .�, . . . y : � ; . . . . y . m . . . . . � , � . , . . . . p ' ' . . . . .,i . . . . . � . y . . . . . y . p, . . . . .., . o • ,; . . . L - . �, . . >. • -.� - x • o� . . y . ya . U , .-1 • O • 7 • O • O� • i.� • U • yJ • o� • tC • 0/ • W • O a • P! • m - - en � . � . . � . . y . y . y , y, • a • .i - • m � v c o � c m L d � ,q o m,O U o� � y, w ro. a�i h� O�� i0 W w i�i • v�! X 4 t� � d O • u U w 0 C r+ a� y �tl O O•.� O'C .C! C•� d �tl +� +� a> eo O w E mmv�axN.�•.�c�o m m m N U•.� -.1 m C U m U C-•r -.� O.-� �6 S.i 61 C U a E s�+ w m 4roi a> A � � 0�7 U� Q 5 U F Z � � � 0 M C � O U U C d � `:. AMERICA ONLINE, INC. NOTES TO CO�IDENSED CONSOLIDATED FIi�TANCIAL STATEMENTS Note 1. Basis of Presentation The accompanyin� unaudited condensed consolidated financial statements, which include the accounts of America Online, Inc. (the "Company") and its wholly arid majority owned subsidiaries, have been prepared in accordance «-ith generall�� accepted accounting principles for interim financial information and with the instructions to Form 10-Q and .�rticle 10 of Regulation S-X. Accordingly, they do not include all of the information and footnotes required by �encrall�• accepted accounting principles for complete financial statements. In the opinion of management, �all ad�ustments, consisting only of normal recurring accruals considered necessary for a fair presentation, ha��e been �ncluded in the accompanying unaudited financial statements. All sib ificant intercompany transactions and balances ha�-e been eliminated in consolidation. Operating results for the three months ended September 30, 19�)9 are not necessarily indicative of the results that may be expected for the full year ending June 30, 2040. For further �nformation, refer to the consolidated financial statements and notes thereto, included in the Company's Annual �eport on Form 10-K for the fiscal year ended June 30, 1999. Note 2. Earnin�. Pcr Share The follo�� i:i�_ table sets forth the"computarion of basic and diluted earnings per share for the three months ended September ?0. 1999 and 1998: (in millio�: ex_c�: for �ez share data) Basic ea_^:- ' °!:a=�: ..__ . _. ., Net ir.c�r..e a•:a::a�:e �o co�snon shareholders ............. ...................... Weiahte� a:•era3� s.`.a:es o::tstanding ........................................... Three months ended September 30, 1999 1998 $ 164 $ 76 -------- -------- 1,110 997 Sasic ea=::�=s Pe= s::a=e ...................................................... S 0.17 S O.CB Diluted eacr._-a� a°. sh=_�e: Net inco:�e a:•a::a::e to common shareholders ................................... 5 184 5 76 Interest ca c:-•:e:�:ble cebt, net of tax ...................................... 2 - Adjusted ae� :r.cor..e arailable to co�non shareholders asst:a:i^a cc::•:ezs:oa .............•••••........•••..........•••••............ Weighted averace s!:ares outstanding ........................................... Effect of d:ls:i�•e securities: Employee s�ock optioas ..................................................... Wazrants................................................................... Convertible deb: ........................................................... Adjusted weighted average shares and assumed convezsioas ...................... Di2uted earnincs per share ................••••••-.........•••-•••••••••••..... 7 -------- -------- $ 186 $ 76 1,110 997 157 174 - 28 20 - -------- -------- 1,287 1,199 $ 0 14 $ 0.06 Note 3. Comprehensive Income For the three months ended September 30, 1999 and 1998, compr..nensive income was $440 million and $31 million, respectively. The difference between net income and `comprehensive income for each period presented is due to net unr.ealized gains or losses on available-for-sale securities. Note 4. Merger and Restructurina Charges During fiscal 1999, the Company recorded the following charges related to mergers and restructurings: Approximately $15 million of direct costs primarily related to the mergers of MovieFone, Inc. ("MovieFone"), Spinner Networks Incorporated ("Spinner") and Nullsoft, Inc. ("I�Tullsoft"). These charges primarily consisted of investment banker fees, severance and other personnel costs, fees for legal and accounting services and other expenses directly related to the transaction. Approximately $78 million of direct costs primarily related to the mergers of Netscape and When, Inc. and the Company's reorganization plans to integrate Netscape's operations and build on the strengths of the Netscape brand and capabilities. This charge primarily consists of investment banker fees, severance and other personnel costs (related to the elimination of approximately 850 positions), fees for legal and accounting services and other expenses directly related to the transaction. Approximately $2 million in merger related costs in connection with the merger of AtWeb, Inc. These expenses were primarily associated with fees for investment banking, legal and accounting services, severance costs and other related charges in connection with the transaction. The following table summarizes the activity during the period ended September 30, 1999. The balance of the restructuring accrual is included in other accrued expenses and liabilities on the consolidated balance sheet and is expected to be paid by the end of this fiscal year. (in millions) Balance Balaace June 30, Non Cash September 30, 1999 items Payments 1999 Banking, legal, regulatory and accounting fees........... $ 4 Severance and related costs..... 11 Facilities shutdown costs....... 8 Miscellaneous expenses.......... (3) - $ (3) (2) (3) - (1) Total ........................... 520 S (2) 5 (7} Note 5. Segment Information $ 1 6 7 (3) $I1 There are no intersegment revenues between the two reportable segments. Shared support service functions such as human resources, facilities management and other infrastructure support groups are allocated based on usage or headcount, where practical, to the two operating segments. Charges that cannot be allocated aze reported as general & adminis�ative costs and are not allocated to the segments. Special charges determined to be significant aze reported separately in the Consolidated Statements of Operations and are not assigned or allocated to the segments. All other accounting policies are applied consistently to the segments, where applicable. A summary of the segment financial information is as follows: Revenues: interactive Oaline Services ................. Enterprise Solutions ........................ Total revenues .......................... Income (loss) from operations: Interactive Online Services (1) ............. Enterprise Solutions (2)..•.--••••••-•••••• General & Administrative .................... Total income from operations............ Three months ended September 30, 1999 1998 ------------ ----------- (Amounts in millions) $1,345 $ 898 222 101 ------------ ----------- 51,467 $ 999 5 356 $ 166 26 (7) (117) (82) ------------ ----------- $ 265 $ 7? 1. For the periods ended September 30, 1999 and 1998, Ir_teractive Online Services include goodwill,and other intangible assets amortization of $18 million and $16 million, respectively. 2. Enterprise Solutions amortization of goodwill and other intangible assets is immaterial for periods presented. Note 6. Subsequent Events On October 20, 1999, the Company entered into a strategic relationship with Gateway, Inc. to increase growth of the Company's services. As part of the agreement, the Company will invest $800 million in common and preferred stock in Gateway, Inc. over a two-year period. Of the $800 million, $180 million will be the Company's common stock and the remainder will be cash. In addition, Gate�vay, Inc. will make an $85 million commitment to market software and Gateway, inc. products and services on the Company's brands. The Company expects to take a pre-tax charge of �30 million in connection with its acquisition of an interest in Gateway.net subscribers in the quarter in which the transaction closes. On October 28, 1999, the Company's stockholders approved an amendmerit to the Company's Restated Certificate of Incorporation to increase the authorized number of shares of common stock from 1,800,000,000 to 6,000,000,000. On October 28, 1999, the Board of Directors of the Company declared a two-for-one common stock split, to be effected in the form of a stock dividend. On the payment date of November 22, 1999, stockholders will receive one additional share for each share owned on the record date of November 8, 1999. The impact of this stock split is not reflected in the accompanying financial statements. Note 7. Legal Proceedings The Department of Labor ("DOL") is investigating the applicability of the Fair Labor Standards Act ("FLSA") to the Company's Community Leader program. The Company believes the Community Leader program reflects industry practices, that the Community Leaders are volunteers, not employees, and that the Company's actions comply with the law. The Company is cooperating with the DOL, but is unable to predict the outcome of the DOL's investigation. Former volunteers have sued the Company on behalf of an alleged class consisting of current and former volunteers, alleging violations of the FLSA and comparable state statutes. The Company believes the claims have no merit and intends to defend them vigorously. The Company cannot predict the outcome of the claims or whether other former or current volunteers will file additional actions. 9 MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Overview Founded in 1985, America Online, Inc., (the "Company") based in Dulles, Virginia, is the world's leader in interactive services, Web brands, Internet technologies and electronic commerce services. The Company operates two worldwide subscription based Internet online services, the AOL service, with more than 19 million members, and the CompuServe service, with more than 2 million members; several leadin� Internet brands including ICQ, AOL Instant Messenger and Digital City, Inc.; the Netscape Netcenter and AOL.COM Internet portals; the Netscape Communicator client software, including the Netscape Navigator browser; AOL MovieFone, the nation's number one movie listing guide and ticketing service; and Spinner and Nullsoft, leaders in Internet music. Through its strategic alliance with Sun Microsystems, Inc., the Company also develops and offers easy-to-deploy, end-to-end electronic commerce and enterprise solutions for coinpanies operating in and doing business on the Intemet. Consolidated Results of Operations Revenues The following table and discussion highlights the revenues of the Company for the three months ended September 30, 1999 and 1998: Three Months Ended September 30, 1999 1998 --------------- --------------- (Dollars in millions) Revenues: Subscriptioa services ................................... $ 995 67.s� $ �23 �2.4� Adveztising, commerce and other ......................... 350 23.9 175 17.5 Enterprise solutions .................................... 122 8.3 101 10.1 ------- ------- ------- ------- Total revenues .......................................... $1,467 100.Oir $ 999 100.0� Subscription Services Revenues For the three months ended September 30, 1999, subscription services revenues, which are generated mainly from subscribers paying a monthly membership fee, increased from $723 million to $995 million, or 38%, over the three months ended September 30, 1998. This increase is comprised of an increase in AOL subscriprion services revenues of $268 million, as well as an increase in CompuServe subscription services revenues of $4 million. The increase in AOL subscription services revenues �vas primarily attributable to a 36% increase in the average number of AOL revenue generating subscribers for the three months ended September 30, 1999, compared to the three months ended September 30, 1998, as well as a 3% increase in the average monthly subscription services revenue per AOL subscriber. At September 30, 1999, the Company had approximately 18.7 million AOL service subscribers, including 16.2 million in the United States and 2_5 million in the rest of the world. Also at that date, the Company had approximately 2.2 million CompuServe service subscribers, with 1.3 million in the United States and 900,000 in the rest of the world. 10 Advertising, Commerce and Other Revenues The following table summarizes the material components of advertising, commerce and other revenues for the three months ended September 30, 1999 and 1998: ` Three Months Ended September 30, 1999 1998 --------------- --------------- (Dollars in millions) Adveztising and electronic commerce fees ................ S 272 77.7ir $ 132 75.4� Merchandise ............................................. 47 13.4 21 12.0 Othez................................................... 31 8.9 22 12.6 ------- ------- ------- ------- Total advertising, commerce and other reveaues.......... S 350 100.0� $ 175 100.0& Advertising, commerce and other revenues, which consist principally of advertising and related revenues, fees associated with commerce and the sale of inerchandise across the Company's multiple brands, increased by 100%, from $175 million in the quarter ended September 30, 1998 to $350 million in the quarter ended September 30, 1999. The increase is primarily attributable to additional advertising on the Company's AOL service, Netcenter portal, a.nd from the Company's other brands, as well as an increase in commerce fees. Advertising and commerce fees increased by 106%, from $132 million in the three months ended September 30, 1998 to $272 million in the three months ended September 30, 1999. Merchandise sales increased by 124%, from $21 million in the three months ended September 30, 1998 to �47 million in the three months ended September 30, 1999. This increase is mainly ariributable to improved response rates to advertising, as well as a larger base of subscribers. At September 30, 1999, the Company's advertising and commerce backlog, representing the contract value of advertising and commerce agreements signed, less revenues already recognized from these aa eements, was approximately S2 billion, up approximately $500 million from June 30, 1999. Enterprise Solutions Revenues Enterprise solutions revenues, which consist principally of product licensing fees and fees from technical support, consulring and training services increased by 21%, from $101 million in three months ended September 30, 1998 to $122 million in the three months ended September 30, 1999. The increase was primarily driven by revenues generated from the alliance with Sun Microsystems, Inc., which did not exist during the three months ended September 30, 1998. Costs and Expenses The following table and discussion highlights the costs and expenses of the Company for the three months ended September 30, 1999 and 1998: Thzee Moaths Ended September 30, 1999 1998 --------------- --------------- (D011ars in millioas) Total reveaues .......................................... 51,467 100.0� $ 999 100.0� Costs and expeases: Cost of reveaues ........................................ 5 791 53.9� 5 583 58.4� Sales and mazketing ..................................... 209 14.2 174 17.4 Product development ..................................... 67 4.6 6� 6.7 Geaeral and admiaistrative .............................. 117 8.0 82 8-2 Amortization of goodwill aad other intaagible assets.... 18 1.2 i6 1.6 ------- ------- ------- ------- Total costs and expenses ................................ $1,202 81.9� $ 922 92.37c 11 Cost of Revenues Cost of revenues includes network-related costs, consisting primarily of data network costs, personnel and related costs associated with operating the data centers, data network and providing customer support, consulting, technical support/training and billing, host computer and network equipment costs, the costs of inerchandise sold, royalties paid to information and service providers and royalties paid for licensed technologies. For the three months ended September 30, 1999, cost of revenues increased from $583 million to �791 million, or 36%, over the three months ended September 30, 1998, and decreased as a percentage of total revenues from 58.4% to 53.9%. The increase in cost of revenues in the three months ended September 30, 1999 was primarily attributable to increases in data network costs, as well as personnel and related costs associated �vith operating the data centers, data network and providing customer support, consulting, technical supportltraining and billing. Data network costs increased primarily as a result of the larger customer base and increased usage per customer. Personnel and related costs associated with operating the data centers, data network and providing customer support and billing increased primarily as a result of the requirements of supporting a larger data network, larger customer base and increased subscription services revenues. The decrease in cost of revenues as a percentage of total revenues in the three months ended September 30, 1999 was primarily ariributable to growth of the higher margin advertisinJ, commerce and other revenues, as �vell as a decrease in network-related costs as a percentage of subscription services revenue. The decrease in network-related costs as a percentage of subscription services revenue was primarily driven by a 19% decrease in our hourly network cost for the three months ended September 30, 1999. This decrease �vas mostIy offset by an increase in daily member usage, from an average of nearly 47 minutes per day in the three months ended September 30, 1998 to an average of 55 minutes per day in the three months ended September 30, I999. Sales and Marketing Sales and marketing expenses include the costs to acquire and retain subscribers, the operating expenses associated with the sales and marketing organizations and other general marketing costs to support the Company's multiple brands. For the three months ended September 30, 1999, sales and markefing expenses increased from $174 million to $209 million, or 20%, over the three months ended September 30, 1998, and decreased as a percentage of total revenues from 17.4% to 142%. The increase in sales and marketing expenses for the three months ended September 30, 1999 was primarily attributable to an increase in direct subscriber acquisition costs related to the AOL and CompuServe services and brand advertising across multiple brands. The decrease in marketing expenses as a percentage of total revenues for the three months ended September 30, 1999 was primarily a result of the substantial growth in total revenues. Product Development Product development costs include research and development expenses and other product development costs. For the three months ended September 30, 1999, product deve]opment costs were unchanged at $67 million and decreased as a percentage of total revenues from 6.7% to 4.6°/a. The decrease in product development costs as a percentaae of total revenues for the three months ended September 30, 1999 was primarily a result of the substantial growth in total revenues. General and Administrative For the three months ended September 30, 1999, general and administrative expenses increased from $82 million to $117 million, or 43%, over the three months ended September 30, 1998, and decreased as a percentage of total revenues from 8.2% to 8.0%. The increase in general and administrative costs for the three months ended September 30, 1999 was primarily attributable to higher personnel costs, including payroll taxes associated with employee stock option exercises. The decrease in general and administrative costs as a percentage of total revenues for the three months ended September 30, 1999 was mainly a result of the substantial growth in total revenues. 12 Amortization of Goodwill and Other Intangible Assets Amortization of goodwill and other intangible assets increased to � 18 million in the three months en6ed September 30, 1999 from $16 million in the three months ended September 30, 1998. The increase in amortization expensa in the three months ended September 30, 1999 is primarily attributable to goodwill associated with the acquisition of the CompuServe online service in January 1998, with minor subsequent adjustments. Other Income, Net Other income, net consists primarily of inveshnent income and non-operating gains net of interest expense and non-operating charges. The Company recorded other income of $37 million and $5 million in the three months ended September 30, 1999 and 1998, respectively. The increase in other income in the three months ended September 30, 1999 was primarily attributable to interest income. The increase in interest income is due to a higher cash balance and interest eamed on investments. Provision for Income Taxes The provision for income taxes was $118 million and S6 million in the three months ended September 30, 1999 and 1998, respectively. Income tax expense for the three months ended September 30, 1999 includes $117 million for U.S. federal and state income taxes and $1 million for foreign taxes. As of September 30, 1999, the Company had net operating loss carryforwards of approximately �8.2 billion available to offset future U.S. federal taxable income. Segment Results of Operations The Company operates two major lines of business: Interactive Online Services and Enterprise Solutions. For further information regazding segments, refer to Note 5 of the Notes to Consolidated Financial Statements. A summary of the segment financial information is as follows: Revenues: Zateractive Online Services ................. Enterprise Solutions .....:............•-••••- Total revenues .......................... income (loss) from operations: Interactive Online Services (1) ............. Enterprise Solutioas (2).-...-.•-•-•••••••• General & Administrative .................... Total iacome from ooerations............ Three moaths ended September 30, 1999 1998 ------------ ----------- (Amounts in millions) $1,345 S 898 122 101 ------------ ----------- 51,467 S 999 5 356 $ 166 �6 (71 (117) (82) ------------ ----------- S 265 5 �� Foz the periods ended September 30, 1999 and 1998, Intezactive Online Services include goodwill and other intangi.ble assets amortizatioa of S18 millioa aad 516 millioa, respectively. Enterprise Solutioas amortization of goodwill and other intaagible assets is icmnaterial for periods preseated. For an overview of the segment revenues, refer to the consolidated results of operations discussion earlier in this secrion. Interactive Online Services income from operations increased from � 166 million in the three months ended September 30, 1998 to $356 million in the three months ended September 30, 1999. This increase is primarily the result of increases in subscription services revenues and advertising, commerce and other revenues, coupled with improved margins and a decrease in marketing expenses as a percentage of total revenues. 13 Enterprise Solutions income (loss) from operations improved from a loss of $(7) million in the three months ended September 30, 1998 to income of $26 million in ,the three months ended September 30, 1999. 'I'��is improvement was mainly attributable to the increase in revenues, as well as a decline in operating expenses, as the Company began to realize efficiencies from using the AOL infrastructure to support the Enterprise Solutions segment as well as the other lines of businesses. In addition, Enterprise Solutions is experiencing benefits from the Sun Alliance which was not in place a year ago. Liquidity and Capital Resources The Compam• is currently financing its operations primarily through cash generated from operations. In addition, the Company has _enerated cash from the sale of its capital stock, the sale of its convertible notes and the sale of marketable secuntics �t held. The Company has financed its investments in telecommunications equipment principally through leasin�. \et cash provided by operating activities was �472 million and �120 million in the three months ended September 30, 1999 and 1998, respectively, and increased primarily due to the Company's increase in net ineome before taxes. \et cash used in investing activities was $123 million and $65 million in the three months ended September ?U. 1999 and 1998, respectively, and increased mainly due to the Company's purchases of property and equipment. \et cash provided by financing activities was $94 million and $602 million in the three months ended September ?0. 1999 and 1998, respectively. Included in financing activities for the three months ended September 30, 199S, ��as S>j0 million in aggregate net proceeds from a public stock offering of its common stock. The Compan}' currentl� has approximately $450 milIion available under a shelf registration filed in June 1998. In May 1999, the Com� an� filed a registration Statement to raise an additional $4.5 billion by sale of the Company's debt securities, common stock, preferred stock depositary shares, warrants or stock purchase contracts to purchase common stock o: preferred stock. The total offering price of securities under these registration statements, in the aggregate, �vill not exceed'S� billion. The Compan�� e�pects to continue using its working capital to finance ongoing operations and to fund marketin� programs and the development of its products and services. The Company plans to continue to invest in subscriber acquisition, retcntion and brand marketin� to expand its subscriber base, as well as in network, computing and support infr�s:ructure. Additionally, the Company expects to use a portion of its cash for the acquisition and subsequent fundm: of technoloaies, content, products, investments or businesses complementary to the Company's current business. Thc Company anticipates that cash on hand, cash provided by operating activities and cash available from the capital markets and traditional lending markets will be sufficient to fund its operatioris for the next twelve months. Earnings Before lnterest, Ta�es, Depreciation and Amortization ("ESITDA") The follo�t��n� table and discussion summarizes EBITDA for the three months ended September 30, 1999 and 1998: Thzee Months Ended September 30, 1999 1998 ------------ ------------ (Anouats in millions) ESITDA ...................................... $386 $153 The Company defines BBITDA as net income plus: (1) provision/(benefit) for income taxes, (2) interest expense, (3) depreciation and amortization and (4) special charges/(gains). EBITDA is presented and discussed because the Company considers EBITDA an important indicator of the operarional strength and performance of its business including the ability to provide cash flows to service debt and fund capital expenditures. EBITDA, however, should not be considered an alternative to operating or net income as an indicator of the performance of the Company, or as an alternative to cash flows from operating activities as a measure of liquidity, in each case determined in accordance with generally accepted accounting principles ("GAAP"). For the three months ended September 30, 1999, EBITDA increased from $153 million to $386 million or 152% over the three months ended September 30, 1998. The EBITDA margin (EBITDA divided by total revenues) 14 increased from 153% for the three months ended September 30, 1998 to 26.3% for the three months ended September 30, 1999. In addition, the incremental EBITDA margin (the current quarter increase over the year ago quarter in EBITDA of $233 million divided by the increase in revenues of $468 million for the same periods) increased nearly 50%. This increase in the incremental EBTTDA margin is mainly due to the shared infrastructure that supports the Company's multiple brands; as these brands begin to generate additional revenues, a larger percentage of each incremental dollar flows to EBITDA. Year 2000 Compliance The Company utilizes a significant number of computer software programs and operating systems across its entire organization, including appiications used in operating its online services and Web sites, the proprietary software of the AOL and CompuServe services, Netscape software products, member and customer services, network access, content providers, joint ventures and various administrative and billing functions. To the extent that these applications contain source codes that are unable to appropriately interpret the upcoming calendar year 2000, some level of modification, or even possibly replacement may be necessary. In 1997, the Company appointed a Year 2000 Task Force to perform an audit to assess the scope of the Company's risks and bring its applications into compliance. This Task Force has overseen testing and is continuing its assessment of the Company's company-wide compliance. The Company's system hardware components, client and host software, current versions of Netscape software products and corporate business and information systems have been tested and continue to be reviewed. To date, the Company has expenenced fe�v problems related to Year 2000 testing, and the problems that have been identified either have been addressed or are in the process of being addressed. The Company has-made Year 2000 compliant certain versions of the client software for the AOL service and the CompuServe service that are available on the Windows and Macintosh operating systems, as well as certain versions of Netscape software products that are currently shipped. While the majority of AOL and CompuServe members use proprietary client soft�vare that is compliant, a third-party Intemet bro�vser utilized in most versions of the client software may not be Year 2000 compliant. A free patch or upgrade will be required for members using some versions of the client soflware or browser to achieve Year 2000 compliance. The Company is encouraging members of its online services to upgrade their browser and/or their software to versions that are Year 2000 compliant, if they have not already done so. The Company is making available to members, and is communicating that availability, free patches or upgrades that can be downloaded from the online services. The Company has not tested, and does not expect to certify as Year 2000 compliant, certain older versions of the AOL and CompuServe softvvare. The Company has developed, and is implementing over the remainder of the year, a communication program that informs members how to obtain the free patch or upgrade to a Year 2000 compliant version of the client software or browser. With respect to the Company's Netscape software business, testing has been completed on currently shipped products and the review and analysis of the testing results continues. The Company is making available at no additional cost to customers any required patch or upgrade to the versions of Netscape softwaze products currently being shipped to customers and is communicating theff availability. In addition, the Company is encouraging customers to upgrade to versions of the software that are expected to be Yeaz 2000 compliant, if they have not already done so. In addition, the Company is continuing to gather information from its vendors, joint venture partners and content partners about their progress in identifying and addressing problems that their computer systems may face in correctly processing date informarion related to the Year 2000. The Company continues its efforts to seek reassurances re�arding the Year 2000 compliance of vendors, joint venture partners and content partriers. In the event any third parties cannot timely provide the Company with content, products, services or systems that meet the Year 2000 requirements, the content on the Company's services, access to the Company's services, the ability to offer products and services and the ability to process sales could be materially adversely affected. The costs incurred through September 30, 1999 to address Year 2000 compliance were approximately $16 million. The Company currently estimates it wiIl incur a total of approximately �20 million in costs to support its 15 compliance initiatives. The Company cannot predict the outcome of its Year 2000 program, whether third parry systems and component sofiware are, or will be Year 2000 compliant, trP costs required to address the Year 2000 issue, or whether a failure to achieve substantial Year 2000 compliance will have a material adverse effect on tne Company's business, financial condition or results of operations. Failure to achieve Year 2000 compliance could result in�some interruptions in the work of some employees, the inability of some members and customers to access the Company's online services and Web sites or errors and defects in the Netscape products. This, in turn, may result in the loss of subscription services revenue, advertising and commerce revenue or enterprise solution revenue, the inability to deliver minimum guaranteed levels of traffic, diversion of development resources, or increased service and warranty costs. Occurrence of any of these may also result in additional remedial costs and damage to reputation. The Company has developed a contingency plan to address possible Year 2000 risks to its systems. The plan identifies a hierarchy of critical functions, acceptable delay times, recovery strategies to return funcrions to operational status and defines the core team for managing this recovery process. The Company will continue to modify this plan to address systems of its recent acquisitions. Forward-Lool:ing Statements This report and other oral and written statements made by the Company to the public contain and incorporate by reference forward-lookina statements within the meaning of the "safe harbor" provisions of the Private Securities Litigation Reform Act of 1995. In particular, statements regarding the following subjects are forward-looking: future financial and operating results; anticipated subscriber, usage and commerce growth; new and developing markets, products, services, features and content; anticipated timing and benefits of acquisitions and other alliances and relationships; the availability, benefits, and timing of deployment of new access and dish-ibution technologies; and regulatory developments, including the Company's ability to shape public policy in, for example, telecommunications, privacy and tax areas. The forward-looking statements are based on management's current expectations or beliefs and are subject to a number of factors and uncertainties that could cause actual results to differ materially from those described in the forward-looking statements. For a discussion of factors that could cause actual results to differ materially from those described in the forward-looking statements, please refer to the section entitled "Forward-Looking Statements" in the Company's Annual Report on Form 10-K for the year ended June 30, 1999. Item 3. Quantitative and Qualitative Disclosures About Market Risk Market risk is the potential loss arisina from adverse changes in market rates and prices, such as foreign currency exchange and interest rates. The Company is exposed to immaterial levels of market risks, including these types of risks. The Company does not enter into derivatives or other financial instruments for trading or speculative purposes. From rime to time, the Company has entered into financial instruments to manage and reduce the impact of changes in foreign currency exchange rates. In June 1998, the Company initiated hedging activities to mitigate the impact on intercompany balances of changes in foreign exchange rates. The Company uses foreign currency forward exchange con�acts as a vehicle for hedging these intercompany balances. A foreign currency forward exchange con�act obligates the Company to exchange predetermined amounts of specified foreign currencies at specified exchange rates on specified dates and to make or receive an equivalent U.S. dollar payment equal to the value of such exchange. For these contracts that are designated and effective as hedges, realized and unrealized gains and losses resulting from changes in the spot exchange rate (including those from open, matured and terminated contracts) are included in other income and net discounts or premiums (the difference between the spot exchange rate and the forward exchange rate at inception of the contract) are also accreted or amortized to other income, over the life of each contract, using the straight-line method. These gains and losses offset gains and losses on intercompany balances, which are also included in other income. The related amounts due to or from counterparties are included in other assets or other liabiliries. In general, these foreign currency forward exchange con�acts mature in three months or less. The estimated fair value of the contracts are immaterial due to their short-term nature. z PART II. OTHER Il\'FORi1�iATION Item 6. Exhibits and Reports on Form 8-K (a) Exhibits Exhibit 3.1 Certificate of Amendment of Restated Certificate of Incorporation of America Online, Inc. (b) ' Reports on Form 8-K None 17 AMERICA ONLINE, INC. SIGNATURES � Pursuant to the requirements of the Securities Exchange Act of 1934, the regish�ant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized. AMERICA ONL C. DATE: November 2, 1999 SIGNATURE: ephen M. Case Chairman of the Board and Chief Executive Officer DATE: November 2, 1999 SIGNATURE `�• � . J. Michael elly Senior Vice President and Clue inancial Officer 18 Exhibit Index Exhibit 3.1 Certificate of Amendment of Restated Certificate of Incorporation of America Online, Inc. � 19 Exhibit 3.1 CERTffICATE OF AMENDMENT OF RESTATED CER'TIFICATE OF �NCORPORATION OF AMERICA ONLINE, INC. ' � America Online, Inc., a Delaware corporation duly organized and existing under the General Corporation Law of the State of Delaware (the "Corporation"), does hereby certify: FIRST: That Section A of Article FOURTH of the Restated Certificate of Incorporation is hereby amended to read in its entirety as follows: FOURTH: A. The total number of shares of all classes of stock which the Corporation shall have authority to issue is 6,005,000,000 shares, divided into two classes, consisting of: 6,000,000,000 shares of Common Stock, par value one cent ($0.01) per share (the "Common Stock"); and 5,000,000 shares of Preferred Stock, par value one cent ($0.01) per share (the "Undesignated Preferred Stock"). SECOND: That said amendment was duly adopted in accordance with the provisions of Section 242 of the General Corporation Law of the State of Delaware. 1N WITNESS WHEREOF, America Online, Inc. has caused this Certificate of Amendment to be signed by its duly authorized officer this 28th day of October, 1999. /s/Sheila A. Clark Sheila A. Clark Corporate Secretary 20 SECURITXES AND EXCHANGE COMMISSION Washington; D.C. 20��9 FORM 10-K ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCH�NGE ACT OF 1934 For the fiscal year ended Jur.e 30, I999 Commission File Number- 001-12143 AIVIE]�ICA OIoTLII\IE, INC. (Exact name of rcgistrant as specified in its ch3rter} Delaware 54-13221 I O (State or other jurisdiction of (I.R.S. Employer incorporation or organization) Identification \o.) 22000 AOL Way Dulles, Vir;inia (Address of principal executi�'e ofGces) 20166-9323 (zip code) Registrant's telephone number, including area code: (703) 26�-1000 Securities re�istered pursuant to section 12(b) of the Act: (Name of Each Exchange on (Title of Each Class) which P.egistered) -------------------------------------- ------------------------- Common Stock, paz value $.01 pez share New York SCOCk Exchange Preferred Share Pu:chase Rig?�ts New York Stock Exchange Securities reaistered pursuant to section 12(g) of the Act: None Indicate by check mark whether the re�istrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of I934 during the preceding 12 months (or for such shorter period that the re�istrant �vas required to file such repores), and (2) has been subject to such filin� requirements for the past 90 days. Yes X No 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 re�istrant's l:nowled�e, 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. ❑ As of July 30, 1999, the a��regate market value of voting stock held by non-affiliates of the re�istrant,.based upon the closina sales price for the registrant's common stock, as reported on the New York Stock Exchanoe, was approximate]y S104,4 billion (calculated by excludin� shares owned beneficially by directon and officers). Number of shares of reoistrant's common stock ouutanding as of July 30, 1999.......1,108,080,083 DOCUMENTS INCORPOFcATED BY REFERENCE The following documents (or parts thereo� are incorporated by reference inio the followin� parts of this Form 10-K: Certain information required in Part III of this Form l0-K is incorporated from the registrant's Proxy Statement for its 1999 Annual Meetin� of Stockholders. Page 1 Item 1. Business PARTI General Founded in 19S�, America Online, Inc., based in Dulles, Vir�inia, is tne �i�orld's lezder in interactive services, Web brands, Intemet technolo�ies, and el�ctronic commerce services. America Online h�s t�� o major lines of businesses or�anized into four product �roups: • the Interacti�c Ur.li^� Sen�ices business, comprised of the Interactive Sen�ic°s Group, the Interac[ive Properties Group and the AO� L�t�-r.a:io�al Group, and • the Ente;p; is: ��:u::o::s business, comp*ised of tne I�'etscape Enterprise Group. The producc � ro:::�s .:�c described below. The Interacti� e Sen :�c; G: our develops and opzrates branded interactive sen�ices, includin�: • the AOL s�n :�:. :�� o: Id��ide Interret online service with more than 17 million members as of June 30, 1999 • the CompuS_r� � t: n ice, a worldwide Intemet online service with approximately 2 million members • the I�`etscape '::;:rr,;cr, an Internet portal with more than 17 million re�istzrzd users • the AOL.CO.`,' I�:.rn�; po�al . • the I�etsca� c C��:;:r�,��icz:o: client sofnvare, including the Netscape Navigator browser The Interactive F':o,�:r,i�s Group is built around branded properties that operace across multiple services and platforms, such as: • Di�ital Cin, ln: . the \o. 1 branded local content networE: and community �uide on the AOL service and the Internet • ICQ, the �ti o:l�'s l:�d�:�; communications portal that provides instant communications and chat technolo�y • MovieFone, Ir.: ,�h:: r.ation's No. 1 movie �uide and ticketin� service provided throu�h an interactive telephone service and on th� AOL s=n�ice and the Internet • Internet music b: an�s Spinner.com, �Vinamp and SHOUTcast The AOL Intema�ion: � Group oversees the AOL and CompuServe services and operations outside the United States, as well as the Netscape Online s�n i:c, ��hich will be launched soon in the United Kingdom. The Netscape Ent�rp-is� Group focuses on providin� businesses a ran�e of sofnr•are products, technical support, consultin� and training services. Thesc products and services enable businesses and users to share information, manage nenvorks and facilitate electronic commerc�. In November 1995, America Online entered into a strate�ic alliance with Sun Microsystems, Inc. ("Sun"), a leader in network computin� produ:ts and services, to accelerate the growth of electronic commerce. The strategic alliance provides that, over a three-year period, the Company will develop and market, tooether with Sun, client sofnvare and network application and server software for electronic commerce, extended communities and connectivity, includin� sofrware based in part on the Neucape Enterprise Group code base, on Sun code and technology and on certain America Online services features, to business enterprises. � For a discussion of financia] information about the Company's two lines of business, refer to Note 9 of the Notes to Consolidated Financial Statements. Durin� the fiscal year, the Company entered into a number of strategic me;gers. In March 1999, the Company completed its mer�er with Neiscape Communications Corporation and in May 1999, the Company completed its merger with MovieFone, Inc. The Company also completed mer�ers �vith Nullsofr, Inc. and Spinner Nerivorks Incorporated, companies that provide music over the Internet, When Inc., a company that provides a personalized event directory and calendar services, AtWeb, Ine., and PersonaLo�ic, Inc. America Online was incorporated in Delaware on May 24, 1985. The principal executive offices are located at 22000 AOL Way, Dulles, Virginia 20166-9323. The Company's telephone number at that address is (703) 265-1000. Inquiries may also be sent to America Online's Internet address: AOL IR@aol.com, or to the America Online address, AOL IR. Page 2 Interactive Online Services Business Products ankl Services The Company's Interactive Oaline Services business is divided into three major product �roups: the Interactive Services Group, the Interactive Proper[ies Grouo and the AOL Intemational Group. "I�his line of business includes the Company's online and Intemet services, Web propeRi°s and client software. The Company has developed a multiple-brand strate�y of products and services that appeal to complem�ntary and diverse �roups of inembers or users of the Internet. The Company has also developed a multiple-revenue stream strategy designed to b:oaden the sources of revenues from its properties and services beyond subscription revenues to include revenues from sources such as advertising, commerce, licensin� fees and transaction fees. The Compady has au�mented its online services with branded propercies that add features or content across multiple services or plaEforms. Followin� these strategies has enabied the Company to operate the business and irnprove its services and products in a cost-effective manner by utilizing a shared infrastruc[ure performin� core functions. Interacti��e Services Group The Interactive Services Group operates the Company's interactive products: the AOL and Co�puServe services and their related brand and product extensions such as AOL.COM and AOL Instant Messen�er ("AIM"); Netscape Netcenter; and the Neucape Communicator client soft�vare, includin� the Netscape I`avi�ator browser. The AOL Service The Company's AOL service, with 17.6 million members at June 30, 1999, provides subscribers with a global, interactive communiry offerin� a wide variety of content, features and tools. The AOL service also includes simple access to the lntemet ��•ith search functionality throu�h AOL NetFind. The ran�e of content, features, and tools �offered on ihe AOL service includes the followin�: —Online Community—America Online promotes interactive community through electronic mail services, public bulletin boards, the Buddy List feature (for members to �en ea servi et which altows members tohcomemuni ate onlineeinstantaneously to a blocking feature), the AOL Instant Messe � �vithout havin� to access an electronic mailbox, an online communiry center, public or private "meetin� rooms" and interactive conversations (chat). Guest intervie�vs, with paRicipation by members, take place at live "auditorium" events. —Channel Line-Up—Content on the AOL service is arganized into channels, allowin� members to navi�ate the service easily to find areas of interest. Each of the follo�vin� nineteen channels offers informational content and commerce and communiry opportunities: AOL Today, Tews, Sports, Influence, Travel, Intemational, Personal Finance, WorkPlace, Computin�, Research & Learn, Entertainment, Games, Interests, Lifestyles, Shoppin„ Heatth, Families, Kids Only and Local. Content providers on the AOL service include CBS News, Hachette Filipacchi Ma�azines, Bloomberg, The New York Times and Business Week. —Personalization and Control Features—M �ce that sends enma 1 inead ance of important Oevents, lst ck portfol'ios that of features and tools, including a reminder serv automatically update market prices, Maii Controls, which allow members to limit who may send them e-mail and to block certain rypes of e-mail, Favorite Places, w�hich allows members to mark particular Web sites or AOL areas, and Portfolio Direct and News Profiles, which send stories of particular interest to memben. The AOL service offers Parental Controls to help parents form their children's online experience, includQn� ervicehsend n1Q or receivinp files attach d toreama 1 or embedded p ctur sain features (for example, the AOL Instant Messen�er s , � e-mail, or access to premium services}. The Marketing Preferences feature enables members to elect not to receive ceRa�n marketing offers. Later this year the Company plans to introduce its iatest version of the AOL service software, AOL 5.0. New,feWhich be tan "" Calendar," AOL Search and AOL Plus. "You've Got Pictures, � service will include "You've Got Pictures, My testin� in June 1999, �vill allow members to receive their developed photos online, share the photos �vith others via e-mai , or�anize and store photos online and order reprints ar►dke�dates and,other'personalaevents online.eAOL 5 Oewallrfeat eCAOL features that enable members to track appantmenu, y Page 3 Search, 2 new search p*oduct that will enabl� AOL rr.embers to search ttie Internet and AOL's exc!usive content without leavin� the AOL service. The service will also include AOL Plus, a feature that wifl enable mernbers to connect to the AOL service throu�h hi�h-speed broad'oand technolo?ies, incttidin� DSL, cable, satellite and �vireless and will provide addotaones music content to members coneectin� through such broadband technolo�ies. The expanded content «�ili include video, � , and online catalo�ue shoppin� features. The CompuServe Service The CompuServe service, with approximatel}� 2 million members, tar�ets the valu�-oriented portion of the U.S. market and the professional bus�ness-oriented mar].et outside of the U.S. Ic is avaiiable in over 500 cities �vorld�vide, inciudin� in the U.S., Canada and Europe. This fiscal year the CompuSe; ve service launched CompuServe 2000, ne�v sofnvarz that provides faster Internet connections, easier installation and re�istration, expanded ctistomer options, more powerful e-mail fe2tures and simplzr navi�ation. CompuServe also launched a Web site, CompuServe.com, to serve as an Interne[ �ateway for its members. Features on the site include personalized news, updated �veather, favorite links and Web centers hi�hli�htin� specific areas of interest. CompuServe has created a Custom Solutions Division to develop and create co-branded and custom versions of the CompuServe 2000 soft�vare. The Custom Solutions Division will also offer private label Internet solutions for strategic partners. The Netscape Netcenter The Company's Netscape Netcenter Web site (http://www-netscape.com) has more than 17 million re�istered users and offers a variety of products and services, includin� news and information, opportunities to purchase �oods and services, Internet site directories, software, sofnvare downloadsooCe at d NetS arch area,1wLhich helps onsumers and businessescfind�elevant search and navi�ation services, such as the a» � information, and Sma�Browsin�; pro�rammin� channels, such as Lifestyles, Personal Finance or Small Business, which or�anizz content and services for directed broadcast; communications and community services such as e-mail and bulletin board services, which help consumers and businesses connect and communicate; oersonalization services, such as My Netscape Channel, a personalized topical channel that users can customize to their personal interests; Customer l�etcenter, which enables businesses to create their own portals; and opportunities fora�nelrDeli ery Channel bycFedEx a d�herMy I�etscape Networke N tcenter also We b si te b u i l d i n� s e rv i c e, N e t s c a p e S p o rt s C h , promotes the Company's soft�vare and customenter' in��ludes a co�branded v esionsof the Company's AOL`Instant dM ssen� r downloads of certain software products. Ne service and its "Local" channel features content provided by the Company's Di�ital City property' The AOL.COM Web Site The Company's AOL.COM Web site (http�� an`InteOmet�sOearch and ratnng tooluand the AOL Instant MessOen er s rvice) content, feaNres and tools, includin� AOL NetFmd, which ailows Internet users to communicate in real-time with their friends and family. AOL.COM also offers AOL me News,ha opportunity to exchange e-mail on the Internet, �vithout si�ning onto the service, through AOL NetMail, and My personalized news service. Content provided on theeAOh.eC� m any pl n sto on nue to expand content and servi es avail ble adveRisemenu, and white and yellow pa�es directo P through the AOL.COM Web site. . AOL Instant Messen�er (AIM) The Company's AOL Instant Messen�er (AIM) service is a Web-based communications service that enables Internet users to know when other users of the service are onl�i�ni�° he messa�e pops up on the rece er'sscreen instantly1ZThetAIM s rvece messa�es. When an instant messa�e is sent v�a , had over 25 million re�istered users as of June 30, 1999. The AIM service is free, and available for downloadCg on SOrL.C�O�' and on a co-branded basis on the Com etscas otCommunacator� software.�ThedCompanyohasualso annouinced arran�ements to Netscape Netcenter and to users of N p develop co-branded versions of the AIM service with Apple Computer, Inc., Mindspring Enterprises, Inc., Earthlink Networ�: an Juno Online Services, Inc. Version 2.0 of the AIM service ef and accesseto news andeinfo �rmat on;aa�`FileeTrans fera featu e th2 white pages directory features directly from the AIM servi aliows users to share files with other AIM 2.0 users; and a directory of chat and interest areas. Page 4 Neucape Communicator � Web-based wo;d Netscape Communicator is a suite of opef O��a e enables`users o communicatershare and access nformation. I�ecscape processin� and �roup schedulin�. This suite o \avigator, the.browser that serves as the core componenttsca e Nav �ato offers a po nit�and cli kS� aphi �1 usernint rface hat applications on intranets, extranets and the Intemet- I�e P allows users to browse the Intemet's array of nenvo:k resources and participate in commerce across extranets and the Intemet. T�vo versions of the Netscape Communicator are marketed: Netscap� a d offersCSe�ve aldnewsfeatu e�n includinQ thetCon pany's Ti:e latest version, Communicator 4.6, was released in May 199 SmaRBrowsin� technology and sireamin� audio and visuat capebil�it�verfn� aova i ryrof t pi s by enten Br common �ho ds� or consumers can search I�etcenter serviczs and connect to Web s topics (Netscape Internet Keywords) into the browser location bar. Interactive Properties Group The Interactive Properties Group includes and oversees th Then� ouy is also re pons ble'fortdeveloping newOdsst ibuttioln services or platforms, such as Di�ital City, ICQ and MovieFone. � P an s rnuitiple net�vorks that will enable the Company to build or acquire branded properties that operate across the Comp Y services and platforms while benefiting from the Company's common infrastructure. Di�ital City The Company's subsidiary, Di�ital Ciry, Inc., which is owned in par[ by the Tribune Company, is a local online content Chica�o netw•ork that offers a nenvork of local content and community �uides in over 60 U.S. cities, includin� Atlanta, Boston, �, Dallas, Denver, Detroit, Los An�eles, Minneapolis, New York, Orlando, Philadelphia, San Die�o, San Frantisco and vital Ciry includes ori�inal and third-parry news, sports, weather, a local �uide �l'ashington, D.C. Local content provided by Di� and on the Worldwide service �vith directory and classified listin�s and a e�servace"CompuSe De comCNe scape NetCenterteICQ ve content an services on the AOL service, AOL.COM, the CompuServ � �Veb (http://w�v�v.di�italciry.com). Digital City also is availabRient o rovideh on MC IWo ldcomclnternetr offerling itsUinterac e has an agreement �vith MCI �Vorldcom to become the local co p city Duides to its Internet subscribers. ICQ I seek The Company's subsidiary, ICQ Ltd., is an Internet-based communications Web portal site, which utilizes the ICQ (" Y ou") instant communications and chat technoto�y- �e portal site is located at http://www•icq•com. At the end of fiscal 1999, throu�h the "word of mouth" ICQ had nearly 38 million re�istered users, and w�as beieous u e stivUsebs be omela aretof ICQS More than 7.5 million peoa d use ICQ everyday, with more than 1 million simultan os new equivalent on the Internet of invitations from current ICQ users to potential users via e-mail. ICQ has � 99a, wh ch brin�a presence and is used primarily by young, knowled�eable users. ICQ has introduced iu latest software, NOW� content and tools onto to the desktop, including ICQiT!, z built-in suite of intuitive search tools, and the new ICQ community area. The Company acquired the ICQ technology with its focus on interactive community and constant desktop presence, and is developing it into an all-service Web portal that maintains its desktop presence. AOL MovieFone 1999. Through its The Company acquired MovieFone,neeservice, Mov'►eFone. om t1Movi Fone p o ides mi[L ons� of movie�oers each week interactive telephone service and its onli with a complete free directory of movies, showtimes and thel ne entertainment informatione ava lableeacrossyits family oftbrands The Company intends to use MovieFone to enhance the on and to provide speciat events and features for subscribers to and users of its interactive services and produccs. Spinner.com, Winamp and SHOUTcast The Company acquired several Internet music brands in VM i Ol hannels of pro�rammUed�tmusic�n variousrfo�rmats j S Incorporated and Nullsoft, lnc. The Spmner.com Web site offers o content includes over 175,000 son�s, and its music players display song information as the song is played. The music players page 5 also provide links that enable real-time lis[ener f�dn o"S a d SHOLITcastn an�MP3 st zam n � aud,o systemTUlThe SHOUTc st developer of �Vinamp, a branded MP3 player for � lans to mzke these s[reaming au�io system enables individuals to broadcast their own co�tent over the Intemet. The Compzny p mtisic features available to consumers across its brands, as well as to customize them for the audience and partners of the Company's brands. AOL International Group The AOL International Group oversees the AOL and Compus° he Uniteds Kin donat�oAs of,Au�ust 1999,� Shet AOL `aad as the Netscape Online service, «�hich will be launched soon �n CompuServe services had more than 3 million me eb Qi d stributioa arcan� ments inTAus ali�aP Austoria�rs Canad�aLFra�er CompuServe branded services through jofnt ventu Germany, Japan, the Netherlands, Sweden, Switzerland and the United Kin�dom. Globally, members are able to access these services in over 100 countries. Additionally, the al stratey lsis to pro �desconsumersd�vitht lo al ser ri zSCOU�ey in ernational offers local services. The Company's intemation �Y markets featurin� local lan�ua�e, content, marketin� and community. Central to the Company's strategy has been the e� ets. In�addit on, U S1 and globalSSUbscribermto1OhelAOL service car provision of access for all members of intemat�onal throu�h 'oint ventures access selected content and communities offered on the Company's other �lobal�v'desche AOL s�rv ce and/or the CompuServe with Bertelsmann AG entitled "AOL Europe and "CompaServe Europe, p service in several European countries and plans to excend th lderin the Company`o ith anrapproxinm2telY 1B3�elsta e,nand Dr. the w�orld's largest media companies, is a minority stocl.ho Thomas Middelhoff, Bertelsmann's Chairman, is a member oi the Company's Board of Directors. The Company continues to update its services to match the needs of its internationai markets. For example, IAOL Eu ope AOL Europe introduced an unlimited use, fl a new subscr ppon Ifree servi eh nUmid Au�ust�1999anThe Netsc pe90nline service announced plans to launch l�etscape Online, will compete in the emer�in� subscription-free value market in the United Kin�dom and �vill complement the existin� AOL an CompuServe services. . During the past fiscal year, the Company has also taken steps to launch services in several new foreign markets: . Australia: The AOL Australia service ruaes exelus ve loOcal Austral9 nicont nt andlalso offe s members acce snto the and Bertelsmann AG. AOL Australia fea original content available on the international services. . Hong Kong: An AOL-branded service for Hong Konten�in both Chinese and En lishuwih most local,content be ng AOL Hong Kon� service will provide ori�inal ]ocal co � a Hon� Kon� based company that has entered developed or provided by China Internet Corporation In June 1999,' he Company acquired an equity interest in the into a distribution arrangement with the Company. former wholly-owned subsidiary of CIC, China_n ends to uste its in esltment in China�i om�o xpandits commirments portals throu�hout �reater China. The Company i in the region. A Web site, AOL.COM.HK, is currently available in either the En�lish or Chinese lan�uage. The We site includes both a co-branded AOL Instant Messen�er service and the AOL Netfind feature with either En�lish or Chinese lanaua�e search capabilities. . Latin America: In December 1998, the Co nPa he Com any's servoce ato co sumerstin La n America. In June Group of Companies ( Cisneros Group") to br � P 1999, the Brazilian subsidiary of the joint venturblathehendtofB1999O TheOjoint,venmre plansoto launcheserv ces in launch an Intemet online service, AOL Brasil, y Mexico and Ar�entina in 2000, with other markets to be added in the future. The joint venture �vill also be responsib e for the development of the CompuServe brand in Latin America_ Page 6 Advertising and Commerce An impo�cant component of the Company's st leJof nerchandiset�vTOnCo�P2 ycco n nuessto' es abli h a w de var ety of advertis�n� and commerce sources and from the s relationships ��'ith advertising and commer�ce partners tacce�s to a br�oadrse eci on of competP i ely pri c d�easy to-order�produ cs subscribers on the Company's interactive s..rvices with and services. The Company has ��'or:ed to develop n Subscrir t onsl anduadvertosintg fees to! include revenues from�Cadda ional broaden the scope of those revenue sources beyond P sources, such as transaction fees and licensing fees_ TThCComa ny haslentered into advertoPng arran� ments that encompass involved in advertisin� and commerce relat�onship� P multiple brands «•ithin the Compan}�'s family of brands. Additionally, the Company hzs renewed and extended or expanded relationships with existin� advertisin� and commerce paRners. The Company offers its advertisin� and com shi 2ofa articula* onl'►ne ar as oriWeb pa es�for desi�na�t d tilme per ods guaranteed numbers of impre�sions and select sponsor P P o orowin� and active subscriber base and users of its Web- As merchants reco;nize the value in reachin� the Company's lar�e, � � based propeRies, the Company has been able to e o e of the Company's onl ne sferv ces andtproperti san In those t ansa tions, market part�cular �oods or sen�ices within one or m the Company provides its commerce partners oe�cross1aromotonsdand compettiv�ePprricingeand online co,nveniencescfor payments, the opportunity for revenue sharin�, P subscribers. Certain of the transac[ions with P�hase or'a�quireua dae t equ tyonte zst in thetpart err.nPThese quity nvestments receive a warrant to purchase stock or may p are accounted for in accordance «�ith CompdRioncthes°`eq u�l investm nts2can also rep esentlaneadd t onal potentiallsou ce of �eneration at the onset of the deal. In ad , income to the Company upon their disposition. The advertisin� and commerce parcnerships also preC'a esh The Company obta ns revenues from the� saIe of inerchandise by access to a diverse selection of consumer products and s offering for sale to subscribers on its interactive services aloQo meerochandi eutThe Comp nytpromotes os merch nd se prnne paliy hardware and soft«�are products and books and Compan} � . by means of promotional "pop-up" screens and makes its merchandise available in online stores included in various channe stores and in specialiied seasonal or other tar�eted shops. lvetrvork Services Interactive Online Sen•ices Business 7echnolosies The Com any employs a muttiple vendor strate;y in desi�nin„ structurin� and ontroln rotocoUInterne pl otocolt(TCP/IP) P Interactive Online Services business. The Company mana�es AOLnet, a trans er p network of third party nervork service providers, S bs dia' MCI WorldcomtAdvanced Networ ts, Inc AOLnet is nsedBor Corporation, and MCI Wor1dCom, Inc's whopy-owned �Y . the AOL service and certain venions of the CompuServe service in North America. The Company anticipates continuing to build AOLnzt in order to increase its network capacity, provide members of its online services with hi�her speed access and red�urcne n h� nto expand to ppr xima ely 1 25 mDl on modems19ThetAOL serva ce added modems at a rate of approximately 37,50 Y �rew as of ]uly 1999 to achieve over 1.14 million simulcaneous users, the exchan�e of approximately 66 million e-mail messages a day and 468 million Instant Messa�e communications 2n totalPtOhe AOLf serrv cerisbava 1 bleein aOpp oz matelyl1,500 cit eslin local telephone numbers in approaimately 1,000 ciues. I , more than 100 countries. The CompuServe service for versions prior to Compu Re and ComcuServe Inclorpor� tedaa who lyrown dlsub sd�ary of pursuant to a Network Services A�reement amon� the Compa y P MCI WorldCom. The a�reement has an onitial t t he Com Uany has m de eROa n commitm n�ts to nse suchlnetworl: serv� es for under ceRam circumstances. Under the a�reeme , P Page 7 these versions of the ConipuServe service. The smooth operation of and 2ccess capaci'� on these versions of the CompuServe service are dependent on the net�vork services provided under the 2greement and �vould be adversely affecc�d b}� service failures of tne nenvork services provider. The CompuServe service is available in over 500 cities worldwide. i The Company's abiliry to reduce data network costs on a per-ho�.�r basis and to expand the network capaciry may be limitz or impaired under ceRain circumstances. The Company enters into multiple-yzar data communications agreements to suppo;t AOLnei. In connec[ion �vith those agreements, the Company may commit to purchase certain minimum data cornmunications services or to pay a fixed cost fo; the nenr�ork services. Accordin�ly, if the number of subscribers or usage significantly decreases, nehvork costs �vill not co;rzspondingly decrease. Subscribers to the Company's interactive online services m�ay experisnn ud2f e init articular �eo�raphic aeeas.eIn additlonl access numbers from ti-ne to time due to changing patterns of usa�e or peal. � P supply shorta�es exist from time to time for local exchan�z carrier Iines from local telephone companies that the Company requires to expand nenvork capacity noe r,nCanally th ou �h leasin�� Supply shorta�efs,or thesfa lure to obtain the nelcessary ec�uipment, which the Company is financi � p P financin�s for the buildout of AOLnet could impair the Company's abilit}� to expand network capacity. Service Platforms and Access Devices The Company supports a variety of sofnvare platforms, hardware devices and condui[s for access to the Company's interactive online services. Today, the vast majoriry of inembers and users of interactive online services access such services throu�h personal computers. Sofi�•are platforms that the AOL and CompuServe services are available on include primarily the Windo�vs (3.1, 9� and 98) and Macintosh operatin� systems. The Company has established i[s "AOL Anywhere" strategy of makin� the AOL service and features available throu�h multiple connections and multiple devices. The Company intends to ma�:e its interactive online services ava�l nces and sma phones, as eons mer demand and t chnolo�yland commercial vab lety hand-held or pocl.et devices, on]ine applia , permit. The Company is developin� versions of its interactive online software that are customized for use on the various platforms. Features that may be made available on the different platforms include e-mail, ne�vs, stock quo Vhich, wiil be commerce and instant messa�es. The Company's next generation soft�vare for the AOL service, AOL �.0, introduced in the fall of 1999, «'�11 includ�e the nc]uden�U DSLO cablle,� satell e and wbre] ss,nandswoll p ovideoaddit��ioOnalsonline t hrou� h hig h- s p e e d b r o a d b a n d t e c h n o l o � i e s, i � o a m e s, m u S i c content to members connectina throu�h such broadband technolo�ies. The expanded content wi l l in c l u d e v i d e o, � and online catalogue shoppin� features. The Company already has taken steps �nder in15Junetei999, the Company tand 3ComdCorpo ationh announceds arstra egic of its services can be accessed. For exa p, relationship to aive AOL service memb�rs acce tformheIn add t onl the Company h spcontinued development work re a,t d to features of the AOL service on the handheld pla AOL TV, an enhanced interactive television IstemsiPh Ilics Elec on cs9and Network Comput �ruInca(nownkno vn as L berate partners, D I R E C T V, I n c., H ug h e s N e t w o r k S y , P Technology, Inc.), related to the development o?� ' Sf�er�areorlatformt for the s rv O e and co laborat non on combining di� tal manufacture of set top boxes used in the service, P satellite television pro�rammin� with the service.e T� to de elo and deploycelectronic pro rammitn� �uides for� heLAOL T'V use Gemstar's technology and intellectual prop rty P service. In June 1999, the Company formed a strate�ic alliance �vith Hughes Electronics Corporation ("Hughes"), a subsidiary of General Motors Corporation ("General Motors"), to develop and market inte�rated di�ital entertainment and Internet services. The alliance will extend the reach of the C emaoreement�t develop a combinat onls t- op receveOr for1DirecTV and AOL TVt servtces. The alliance, which builds on an earl � provides for extensive cross-promotion and markeiinearitaslwelrasldelivery over iHu hesf n Ot e,nerationesa elli e syHem for DirectPC satellite Internet network beginn�n� nex y , two-way, broadband connectivity. In connection �hitc � esla`6-1/4%ecouponarate and h sla mandatory conve sion Iinto General form of a General Motors preference stock, ��'h�c Motors Class H common stock (GMH) in three yea�rs. ent s Disc� sslionf a datA alysisrof Financ aleCond tioneandl Resu1 od Capital Resources" under PaR 1I, Item 7, "Mana�em Operations." Page 8 The Company has upgrad:d AOLnet to support the v.90 standard for hi�h-speca access at 56 kps, ar,d is a�� al Subscriber the development of alternative tecnnolo�ies to �olo�ies5 1The Company plans toeoffer 1 ts`membel s ho her speed options �vhen Line (xDSL)� access, sat�llit� and �vireless tech � they become easy-to-use a:�d commz;cizlly viable for the mass market. The Company has forrr�ed s�ratio ��2�e available aah oh- Bell Atlantic, SBC Co��«�ications, Ameritech Corp. and GTE Corp. to use new DSL technolo�y the end of 1999, the speed upgrade connectio:i to s�abscribers, �vith the initial roll out be�innin� in the summer of 1999. BY Company expects to offer � ci;h-speed broadband up;radn a��eement wi h Compaqrunder � hOh ne v�Compaq PresanoeIntemet 16 million homes. T�_ CeTa_:':;' also has entered into a � PCs will be equip�ed «�t� D�L-�zady modems and will feature pre-installed AOL sofnvare that avill enable users to access features avaitabl� t�ro::�_� ��==azna. Marketing 7'he Compar.�'s r.�a-�•�:'': ef�orts and activities in �osooals of1theOComp ny'slInte activesOnl ne Servi es business arePto brands through a c��:�:-..� ��`�=��rure. The markettn� � attract and retain r.�e��`�:rs o' �s=�s, 2s applicable, of th'tionl� heSComeany markets its producu and serv ces h`roei�hta broad Company's famil; o` h�.:r.-> i o support member acquisi , P array of pro�rams ::�.:.' �"; ;=: �;s. including broadcas�edia.�rtThe Compan} alsor actively market's it nmultiple b andslsthrough co-mar ketin�, bur. 3:�r.; := rc:�•=� t� 2 n d a l t e m a t e m P P and throu�h more innova tiv e m e a n s, s u c h a s t h r o u � h traditional campai�r�s (^r�--='�� 'levision, radio and rint ublications), � extensive onlin� a�� o`:::^= �"�>;-Promotion and co-brandin� with a wide variety of interactive services partners. Addit�e sonal throu�h bundlin� a_�er''�=�.'•�. ��= Company's interactive online services are on a ran�e of computers made by major p computer manu,`z::urcr> i r.= ��lii-)'ear agreemenQs Panva�reement w th Microsoft Corp.,lthe AOLaserv ceCiscaccess ble v a a durin� the computc:'s i��i�� sc:�p process. Throu�h � desktop folder on th; ��'��•�s 9� and 9S operating systems (and will be available on future versions of the Windows operating system throu�h th: tcrr.. o,` t^e a�reement). The Comp�n� u'ifizes t='=�ted or limited promonline serv ces and t d stin� ish andrdevelop its different brandseaFoo particular groups o` p�:=n:i_I users of its interactrve o example, in conne:cio^ �� i:� t:,e positioning of tQe Coa P es foreits CompuServ selrvc e�vith wo ompu er manufacturers and a and July 1999 thc Co:r.pzn� 2"'ounczd markeun� m number of addicio��l retail;rs linder these promotions, consumers signin� up for three-year memberships to the Compu erve 2000 service at S? 1.9� p:� r�onth ��ill receive a rebate ers who arec urchas n� olmputersfor the p�marylpurpose ofa ettin f computers. This proTO'io- is �:signed to appeal to consum P online and to make tn: purch�s: of a personal computer and Internet access easier and more affordable. The Interactive Onlin: Services business utilizes specialized retention programs desi�ned to inerease memb the re ular loyalty and satisfaction. Th:se retensofn are�rao ramsl and onlinelpromot��ionsaof pcom ngtonl ne events and new features. addition of new content, feacures and P 1"he Company also providzs a variery of support mechanisms such as online support and 24-hour telephone customer suppo services. Enterprise Solutions Business Products and Services The Netscape Enterprise Group is the primary product group in the Enterprise Solutions business of the Company• In addition, the Company has formed Netscape Business Solutions to sell AOL and Netscape products and services to business partners and other companies. Page 9 \etsc r_ Enierprise Group The Netscape Enterprise Group provides enterprise sofnvare and services to businesses tha[ assist therr. in providin� serviczs to customers in the electronic commerce markets. The Netscape Enterprise �roup develops, markets, sells and suppors a broad suite of enterprise sofnyare, �vhich consists of electronic commerce infrastructure and electronic commerce applications tar�eted primarily at corporate intranets and extranets, as �rell as the Internet. The sofnvare allows tisers to share inforrnation, manage neRvorks and take their businesses online. The soft�vare is based on industry-standard protocols that can be deployed across a variety of operating systems, platforms, da[abases and interconnected �vith traditional cliendserver applications. The Netscape Enterprise Group also provides a variety of services to support its sofnvare products, including technical support, professional services and trainin�. .Follo�vin� the mer�er �vith Netscape in March 1999, the Netscape Enterprise Group be�an contributin� to the Company's strategic alliance with Sun Micros}�stems, Inc. (see belo��'). Electronic Commerce Infrastructure The Electronic Commerce Infrastruc[ure is a �rotip of solutions for enterprise customers and Internet Service Providers that provide a flexible, scalable foundation on ��hich the customers can build and mana�e their o�vn extranet or Intemet applications or use the Electronic Commerce Applications. The Electronic Commerce Infrastructurz provides a services-ready platform through such solutions as a directory and securiry service for mana�ing users and applications, an application server for building and deployin� 2pplications, and a messagin� solution for hostin� and delivering communicztions services such as e-mail and unified messa�in�. � Electronic Commerce Applications The Netscape CommerceXpert product family of electronic commerce applications enable businesses to link and mana�e oniine trading communities of suppliers, distributors, and customers of all sizes and de�rees of technical sophistication. The Netscape CommerceXpert solutions are based on the same open protocols and scaIable securiry architecture used for communications on the Internet. These solutions enable organizations to create more secure Internet commerce sites and exchan�e information with tradin� paRners. ' Sun Alliance In iv'ovember 1998, the Company entered into a strategic electronic commerce alliance with Sun, which is now referred to as the Sun-Netscape Alliance. In combination with dedicated resources from Sun, the Netscape Enterprise Group operates the Company's part of the alliance. The alliance builds and markets on a collaborative basis end-to-end electronic commerce solutions to help business partners and other companies put their businesses online. The alliance product portfolio provides customers �vith scalable, integrated infrastructure soft�vare and a family of production-ready electronic commerce applications. Products will be offered on the industry's most widely available computin� platforms. The infrastruccure product portfolio includes: messa�in� (e-mail) and calendar, collaboration, Web, application, directory (net�vork phone book) and ceRificate (securiry) servers. The alliance offers a family of production-ready applications for electronic commerce, includin� commerce exchan�e, procurement, sellin� and billing applications intended to make electronic commerce more efficient. The alliance initially will market and provide existin� products from each of Sun and the Netscape Enterprise Group and then will include collaboratively developed products. The alliance has a dedicated sales force that selis the full suite of produc[s on multiple platforms. Support and integration services are also provided. • Marketing The Company's marketing efforts and activities in its Enterprise Solutions line of business are conducted primarily through joint marketin� efforts of the Sun-Netscape Alliance. The marketin� goals of the Company's Enterprise Solutions business are to position the Sun-Netscape Alliance as the leadin� provider of electronic commerce applications and Internet infrastructure sofnvare to power the Net economy. The Sun-Netscape Alliance has announced that it will develop, market and sell the produccs and systems throu�h the alliance usin� the brand name "iPlanet." The marketin� pro�rams of the Company's Enterprise So]utions business focus on reaching corporate decision makers in its key markets. AdveRising will focus on the Sun-Netscape Atliance's leadership position in the industry, and the breadth and innovation of the iPlanet product portfolio. Advertising media will include the Company's interactive online services and Page 10 properties, traditional prin[ and broadcast advertisin� campai�ns and bundling a�reements. A dedica:ed sales force also markets the products and services sold or provided throu�h the Sun-Netscape Alliance directly to potential customers. The Eriterprise Solutions business utilizes customer marketin� pro�rams desi�ned to increase cus:omer loyalry, customer value over time and customer satisf2ction. These programs include the recen[ly announced iPlanet Customer Pro�ram feaRiring a secure customer extranet and specialized joint marketin� activities, a r;ew customer qualiry initiative and customer suppor[ and services. • Employees As of June 30, 1999, the Company had approzima[ely I2,100 emp;oyees. Americ2 Ociline believes that its relations with its employees are �ood. I�Tone of the Company's employees are represented by a labor union and the Company has never experienced a work stoppage. Proprietary Rights The Company relies upon a combination of contract provisions and patent, copyri�ht, trademark and trade secrec la�vs to protect i[s proprietary rights in its products and services. The Company distributes its products and services under a�reements that �rant members, users or customers a license to use its products and services and relies on the protections afforded by the copyright laws to protect a�ainst the unauthorized reproduction of its products. To license its products, the Company relies in part on "shrink �vrap" licenses that are not signed by the end-eser and, therefore, may be unenforceable und�r the }aws of certain jurisdictions. In addition, the Company attempts to protect its trade secrets and other proprietary information throu�h a�reements �vith employees and consultants. The Company has also filed fo; a number of patents for technolo�y relatin� to the Internet and online industry. Althou�h the Company intends to protect its rights vi�orously, there can be no assurance that these measures will be suecessful. Policing unauthorized use of the Company's products and services is difficult and the steps taken may not prevent the misappropriation of the Company's technolo�y and intellectual property ri?hts. In addition, eifective patent, trademark, trade secret and copyri�ht protection may be unavailable or limited in certain forei�n countries. The Company seeks to protect some of the source code of its products as a trzde secret and as an unpublished copyri�ht work. Source code for certain products has been or will be published in order to obtain patent protection or to re�ister copyri�ht in such source code. Other source code has been distributed under open source code licenses. 'I'he Company has obtained federal trademark re�istration of a number of marks, includin� America Online, AOL, Buddy List, Netscape, Netscape Navi�ator; AOL's trian�le desi�n lo�o; and Netscape's "N" lo�o and ship's wheel logo, and has trademark ri�hts in the U.S. and abroad in many other proprietary names including, AOL.COM, Di�ita! City, ICQ, AOL Instant Messen�er, AOLnet, Ne[scape Netcenter, "You've Got Mail" and CompuServe. T'he Company believes that its products, trademarks and other proprietary ri;hts do not infrin�e on the proprietary ri�hts of third parties. From time to time, however, the Company has received communications from third parties assertin� that features, contents or names of certain of its services or products may infringe patenu, copyrights, trademarks and other ri�hts of such parties. No liti�ation is pending in this area that would have a material adverse effect on the Company's abiliry to develop, market and sell its products or operate its services. There can be no assurance that third parties will not assert infringement claims a�ainst the Company in the future with respect to current or future features or contents of services or products or that any such asseRion may not result in litigation or require the Company to enter into royalry arranaements. Third parties also challen�e the Company's marks from time to time and such challen�es may result in limitation or loss of trademark ri�hu to such proprietaiy marks. Repulatory Environment; Public Policy In the United States and most countries in which the Company conducts its major operations, the Company is not currently subject to direct re�ulation other than pursuant to laws applicable to businesses generally, includin� businesses operatin� in the Internet. Adverse developments in the legal or reaulatory environment relatin� to the interactive online services and Internet industry in the United States, Europe, Asia or elsewhere could have a materia] adverse effect on the Company's business, financial condition and operating resul[s. A number of legislative and re�ulatory proposals from various international bodies and foreign and domestic govemments in the areas of telecommunications regulation, particularly related to the infrastructures on which the lnternet rests, access charaes, encryption standards and related expoR controls, content reoulation, consumer protection, advertising, intellectua] properry, privacy, electronic commerce, and taxation, tariff and other trade barriers, among others, are now under consideration. The Company is unable at this time to predict which, if any, of such proposais may be Pase 11 adopted and, if adopted; ��'hether sitch proe�Com`anulh szsitpportedyceRain proposals designtedtto.en'nan eomarke acess and financial condition and operating result�. Th P Y competition in the offerin� of both na�owband ld have a beneficialreffect on the�devel pme nt oi1thc In emet medi�un and of the believes that t�he adoption of such proposals �rou o redict �vhether an such ro osals ��'ill be adopted. Company's prospects. The Company is unable, a� this tim.., to p. Y P P Moreover, ttte manner in ��hich existiag domestic and forei�n la�vs (includin� Directive 9>>'46/EC of the European Parliament and of the European Council on the pro� to`onl ne`s°��r�vice and Int meazacesshpro odersi s uocertaionasas the effectton free mo�ement of such data) will or ma5� be applied the Company's business �iven different possible apParious� domesticaand tforeC nm aavs �ovembng co.��t�e n,cexport frestri�tionse Company from the potential future application of P p ny, privacy, consumer protection, export controls on encryption technolo�y, tariffs and other trade barners, intelleccual ro e and taxes. The Company actively works both in the United States and intei-nationally �vith industry �roups and alliances, as �vell as public interest �roups and representatives of �ovem Q�at�O° consumereptrote thon,ntaxation ofear.te;ac[ivetservicessand uses privacy measures and policies, obsceniry and pomo� p y, re�ulation of ineans of access to the Intemet and intellecR�aI properry issues such as the application of copleadersa omotin� interactive medium. For example, the Comp2ny is a member of the openNet Coalition, a coalition o,` indus associatio n; znd the open access to broadband t�ea°ooaddress prnvacyeis ules in the nteraet ve mediu�m and is a membeaof he steerin� committees Online Privacy Alliance fo of TRUSTe and BBB Online, each of �vhich is developin� enforcement systems fo: private sector commitments to air information practice principles. The Company believes that industry-led standards t e medeum15The Cornpanyes eks to edu ztatrepresentativeslof ndustry, solutions �vithout restrictin� the furthzr development of th �ovemment and public interest groups on the benefits to sociery of the new interactive services medium an oacheseoutlined likelihood of society's achieving h as�eaben�each �v !l provide a g�reater acceptance of the med�m b} consumePSaround the �vorld above. In the Company's vie�v, su PP P roducts and services. Some of the issues the Company and a more favorable environment for the acceptance of the Com any's p P� is focusin� on are the protection of privacy, online tools to permit user choice of content osacl V1Oies, foster n�ccit ien safeauardin� of children, enhvolvemen �and p otectionl of ntellectual p opertyln The Company has adopted internal policies and and parental education and �n principles re�ardin� these areas and has implemented {eOL service, andlthe Notify AOL featu e thztrenabl srume bers toe eport posted prominently on the Kids Only channel of the A inappropriate activiry on the AOL service, as fuRher suppd whether the d ostive re�u a orynenvi:onmentabehn� tsought by t is whether this approach will be adopted by �overnment an P approach will be forthcomin�. Available Information The Company fi]es annual, quarterly and special reports, p the Comm ssion maytberread or copi dlat the Commission's Exchange Comrnission. Any document the Company files with public reference room at 450 Fifth Street, N.W., Washington, D.C. 20549. Please call the Cornmission at ]-800-SEC-0330 for further information on the public reference room. The Company's Commission filin�s are also available to the public at the Commission's Web site at http:��+'��'��•sec.�ov. Item 2. Properties The Company maintains facilities and offices at various locat►calltcenters, office pace a d headq art rsest of the world for general corporate purposes, including technology centers, customer ine Services business. The Company leases office space in America Online maintains its headquarters facilities in Dul]es, Virginia, and holds various properties at and near t e headquarcers facilities that are used principally in its Interactive Onl New Mexico; Albuquerque, the followin� locations for Customer Call Centers: Tucson, Arizona; Jacksonville, Florida; o erations in Columbus, Oklahoma City, Oklahoma; Ogden, Utah; and the Philippines. The CompuServe service has its primary p Ohio, and has various properties at and near those facilities. Di�ital Ciry leases office space in the United States cities for which i[ Page 12 provides local int�ractive content z�d services. vovieFoi:e )eases oFfice space in 1�'e�� York Cit��, bu: is movin� its operat�on� to leased office space in Wes[chester, New Yo;k. ICQ maintains its operations in Isra:l. The Enterpris-: Solutions busi��ess has iU primary operations in Motintain View, California, and has various oth�r properties throu�hout the Li;�ited S[ates and in otiier coucitries.� The following taole secs forth info,-matiotl on the Cocnpany's m�:erizl p,-ope<<fes: O�aned/Lease Puroose Locatio.^. Sizc ------------------- ---------------------- ------------�-------- ----------------- Colu..^taL us, Oii 7.90, 000 sa. _`t • Owr.ed O:fice oace 590,000 sq. ft.(1) Owned (2) Coroozate FieadcuarCe=s Dulles, vA �Wn�n Tecnnology Cente: Du11es, vA 180,000 sc. ft. Tecnnology Certer(3) 220,000 sc. ft. Owned ldanassas, VP Office Soace t4ountain View, CA 1,055,000 so. ft. O°neaa�2� Tech�ology Cea:e: Res�on, VA 265,000 sa. ft. Of�ice Soace Leased ' San Fzancisco, CA 36,000 sq. fC. p�fice Space Vienna, VA 110,000 sq. ft. Leased (1) Two additional facilities are under construction at this site that, �vhen completed, �vill add 350,000 sq. ft. to the currenc si�e. Both facilities are expected to be completed in 2000. (2) This propeR}� is held subject to a mortgage. o center to be located on (3) The Company acquired 25.5 acres of land in Manassas, Vir�inia in Feb:uary 1999. The technolo�}' the property is under construction and is expected to be completed in e2rly 2000. Item 3. Legal Proceedings ?he Company is a party to various litigatior. matters, investigations and proceedings, includin� a shareholder derivative suit filed in Delaware chancery court a�ainst certain current and fo;mer directors of the Company alle;in� violations of federal securities 1aws. The Company has settled the shareholder derivativ� suit and obtained the approv2l o; the Delaware chancery court on terms that will not have a material adverse effect on the financial condition or results of operations of the Company. The Department of Labor ("DOL") is investi�ating the applicabiliry of the Fair Labor Standards Act ("FLSA") to the Company's Community Leader program. The Company believes.the Communiry Leader program refl�cts industry practices, that the Communiry Leaders are volunteers, not employees, and that the Company's actions comply with the law. 'The Company� is cooperatin� with the DOL, but is unable to predict the outcome of the DOL's investigation. Former volunteers have sued the Company on behalf of an alle�ed class consisting of current and former volunteers, alleoin� violations of the FLSA and comparable state statutes. The Comp the claims or whethe ot er forme or current volunteers a llefia additional acdons. The Company cannot predict the outcome o 'fhe costs and other effects of pending or future litigation, governmental investi�ations, legal and administrative cases and roceedinos (whether civil or crimina]), settlements, jud�ments and investi�ations, claims and chan�es in those matters Pa (includin� those matters described above), and developments or assertions by or a�ainst the Company relating to intellectual properry rights and intellectual property licenses, could have a material adverse effect on the Company's business, financial condition and oper2tin� results. Mana�ement believes, however, that the ultimate outcome of all pendin� liti�ation should not have a material adverse effect on the Company's financial position and results of operations. Item 4. Submission of Matters to a Vote of Security Holders Not Applicable. Page 13 PART II Item 5. Nlarket for Repistrant's Common Equity and Related Stockholder Nlatters Market Price of Common Stock The following table sets forth the ran�e of hi�h and low sale prices for the Company's Common Stock for the periods indicated and reflects all stock splits effzcted by the Company: For the quarGer e�ded: ---------------------- Seotember 30, 1997.... December 31, 1997...._ Dtazch 31, 1998._.....- June 30, 1998......... September 30, 1998..-- December 31, 1998..... Dlarch 31, 1999.--••••• June 30, 1999......... Fiign $ 10.06 $ 11.41 $ 17.47 $ 27.41 $ 35.13 $ 80.00 $153.75 $175.00 Low $ �.06 $ 8.00 $10.3'_ $17_31 517.50 $20.66 $67.00 $89.50 The Company has never declared, nor has it paid, any cash dividends on its Common Stock. The Company currently intends to retain its eamin�s to finance future �rowth and, th�refore, does not anticipate payin� any cash dividends on its Common Stock in the foreseeable fu[ure. As of July 26, 1999, the approximate number of stockholders of record of Common Stock was 24,600. In addition, there were approaimately 1.9 million beneficial holders o,` the Common Stock, representin� persons whose stock is in nominee or "street name" accounts through brokers. Ezchange Information The Company's Common Stock is traded on th: New York Stock Exchan�e under the symbol "AOL." Options on the Company's stock are tr2ded on the Chica;o Board Options Exchan�e, the American Stock Exchange, and the Pacific Stock Exchange. Recent Sales of Unregistered Securities On May 28, 1999, the Company acquired Spitlizer Networks Incorporated in exchan�e for the issuance of approximately 2.4 million shares of Company common stock. The transaction was a private placement and exempt from registration pursuant to Regulation D of the Securities Act of 1933, as amended. On May 28, 1999, the Company acquired Nullsoft, Inc. i�z exchan�e for the issuance of approximately 720,000 shares of Company common stock. The transaction was a private placement and exempt from re�istration pursuant to Regulation D of the Securities Act of 1933, as amended. ' Page 14 Item 6. Selected Financial Data Statemen[ o: Opera:ions Data: . • ..... Subscriptioz serv-ces..._..•••••••••• Advertising, commerce and otner ..--•-•••• Enterprise solutions....._..-•••••-••••••• Total revenues...........-•-••-•-•••-••• . Income (loss) from operations.....-••-•••• Net income (loss) (1)-....--••••-••••••••• Income (loss) per common share: Net income (loss) per share-diluted....... Net income (loss) per share-basic.._...... Weighted average shares ou:standing: Diluted ..................... ._.....----••• Basic..................................... Year Ended June 30, ----------------------------------------- 1999 1998 1997 1996 1995 -------- -------- ------- -------- ------ (A:nounts in millions, exc=p� p_r s'r.are c'ata) $3.322 52,'_83 51,478 $1,024 5352 1,000 543 308 111 SO S56 365 411 188 23 -------- -------- ------- -------- ------ 4,777. 3,091 2,19? 1,323 425 458 i120) (S65? 6S (41) 762 (74) (485) 35 (SSl $ 0.60 $(0.08} $(0.53) 5 0_04 $(0.69J $ 0.73 S(0.08) 5(0.58) S 0.05 S(0.09) 1,277 925 838 944 587 1,041 925 838 751 587 As of June 30, ----------------------------------------- 1999 1998 1997 1996 1995 -------- -------- ------- -------- ------- (Anoun:s ir. nillions) Salance Sheet Data: Wozking capital (deficien�y)••.•••--•- 525� 5108 S(4o) S�z $18 '"" 459 Total assets.........-••-•-••••••-••-••••• 5,348 2,874 1,501 1,271 24 Total debt ...................•-•-••-'"'"�� 3,033 996 610 707 242 Stockholders' e uiC " " 4 Y ..............••-• Other Selected Data: Net cash pzovided by operating activities. Earnings Before Interest, Taxes, Depreciation and Amortization (E3IT�A)(2) Yeaz Ended June 30, ----------------------------------------- 1999 1998 199? 1996 1995 -------- -------- ------- -------- ------- (Amounts in millions) $1,099 ` $437 5131 SZ 968 302 111 238 S18 11 (1) Net income in the fisca! ��ear ended June 30, 1999, includzs special charges of $9� million related to mergers and restructurings, 52� million in transition costs and a net gain of 5567 million related to the sale of investments in Excite, Inc. Net loss in the fiscal year ended June 30, 1998, includes special charges of 575 miilion relatcd to mergen and restructurings, S94 million relatzd to acquired in-process research and development and 517 miilion related to settlements. Net Ioss in the fiscal year ended June 30, 1997, includes special charges of 538� million for the ��•rite-off of deferred subscriber acquisition eosts, $49 million for reswcturing, 5?4 million for contract terminations, 524 million for a legal settlement and 59 million related to acquired in-process reseuch and development. Net income�in the fiscal yeu ended June 30, 1996, includes special char�es of S17 million for acquired in-process research and development and 58 million in merger related costs. Net loss in the fiscal year ended June 30, 199�, includes special charges of 5�0 million for acquired in- procas research and development and 52 million for merger expenses. (2) EBITDA is defined as net income plus: (1) provision/(benefit) for income taxes, (2) interest expense, (3) depreciation and amortization and (4) special charges. For the fiscal years ended June 30, 1997 and prior, EBITDA does not add back the amortization of subscriber acquisition costs. The Company considers EBITDA an important indicator of the operational stren�th and performance of its business including the ability to provide cash flo�vs to service debt and fund capital expenditures. EBITDA, however, should not be considered an alternative to operating or net income as an indicator of the performance of the Company, or as an alternative to cash flo�vs from operating activities as a measure of liquidiry> in each case determined in accordance with generally accepted accounting principles ("GAAP"}. Page 15 Item 7. Manaoement's Discussion and Analysis of Financial Condition and Results of Operations MANAGEi�iEnT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERAT'IONS Overvie�v Founded in 19S�, Ar�=�i:a Online, Inc., ("Ar,lerica Online" or the "Company") based in Dulles, Virginia, is the world's leader in interacti��e ser��i:es, ��'eb br2nds, Internet technolo�ies, and electronic commerce services. The Company operates nvo tivorldwide subscriptio:i b�s=d l�eemet online services, America Online, with more than 17 million members, and CompuServe, �vith approximatel�� 3 r:il�i;.:� mc�nbers; several leadin� Internet brands includin� ICQ, AOL Instant Messenger and Di�ital Ciry, Inc.; the Netscape Netce�te� ar.� AOL.COM Intemet porals; the \'etscape Communicator client sofcware, includin� the Netscape Navi�ator bro�vser; AO� �te� irFone, the nation's number one movie listin� �uide and cicketin� service; and Spinner Networks Incorporated and I�ulls�':. lr� , I:aders in Internet music. Throu�h its strate�ic alliance with Sun Microsystems, Inc., the Company also devzlors �^� offers easy-to-deploy, end-to-end electronic commerce and enterprise solutions fo: companies operatin� in and doin� b�s:�=ss on the lnteme:. T'he Compan�• cu�:-'1� has n�•o major lines of businesses or�anized into four product �roups. These groups are supported by a common infras:n: ^:� ��,.' jc u�� acrossathe m licpleebr,ands ithcurrently hasoasewell as costreffectively compete in new and utilizin� the comrao� � .:..- emer�ing markets. Interactive Online Scn i:cs Business The Intera:trti•c Sc�'ices Group The Interactive Se:�i:es Group operates the Compan}�'s interactive products: the AOL and CompuServe services and their related brand and product e.�tensions, includin� AOL Instant Messen�er and AOL.COM; Netscape Netcenter; and the Netscape Communicator client so.`:��arc, includin� the Netscape Naviga[or browser. This group is also char�ed with rapidly deliverin� hi�h-qualiry, ��•orld-cl�ss p:oducts, features and functionaliry across all branded services and properties and also has responsibility for broa35=nd development and AOL devices like AOL TV. The lnteract�ti �: !'�operties Group The Interactive Prop:�i�s Grovp operates ICQ, Di�ital Ciry, MovieFone, Direct Marketing Services ("DMS"), Spinner Net�vorks Incorpora!e� and Nullsoft, Inc., developer of the Winamp and SHOUTcast brands. This �roup is responsible for buildino new revenue s*.reams by s°ekin� out opportunities to build or acquire branded properties that operate across multiple services or platforms. The AOL Inlerr.otioRal Group The AOL International Group oversees the AOL and CompuServe services outside of the U.S., as well as the recently announced Netscape Online service. The AOL International Group operates the AOL and CompuServe branAOL Japane with iu joint venture partner BeRelsmann AG; AOL Canada, a wholly-owned subsidiary of America Online, Inc.; joint venture partners Mitsui and Nikkei; and AOL in Australia with Bertelsmann. America Online plans to launch services in Hong Kon� with China Internet Corporation and in Latin America w�ttc the Cisneros Group. Netscape Enterprise Solution Business The Netscape Enterprise Group The Netscape Enterprise Group serves Netscape's enterprise customers and contributes to America Online's part of the strateaic alliance with Sun. In combination with dedicated resources from Sun, the Netscape Enterprise Group delivers easy-to- deploy, end-to-end solutions to help business partners and other companies put their businesses online. Page 16 Competition The Company competes with a wide range of other companies in the communications, advertising, entertamment, information,'media, Web-based services, software, technolog}�, direct mail and electronic commerce fields for subscription, advertising, and commerce revenues, and in the development of distribution technologies and equipment in its Interactive Online Services business. The Company also competes �ti�ith a wide range of companies in the development and sale of electronic commerce infrastructure and applications in its Enterprise Solutions btisiness. Competitors for subscriptior, revenues include: — online services such as the Microsofr Nehvork, ATRT Woridnet and Prodi�y Classic — national and locai Intemet service providers, such as MindSprin� and EarthLink — lon� distance and re�iona! t�lephone companies offering access as paR of their telephone service, such as AT�T Corp., MCI WorldCom, Inc., Sprint Co:poration and re�ional Bell operating companies — cable television companies — cable Intemet access services offered by companies such as Excite@Home and Road Runner Group Competitors for advercisin� and commerce revenues include: — online services such as the Microsoft Network, AT&T �'Vor]dnet and Prodi�y Classic — Web-based navigation and search service companies such as Yahoo! Inc., Infoseek Corporation (to be acquired by the Walt Disney Company), Lycos, Inc. and Excite@Home. — global media companies including newspapers, radio and television stations and content providers, such as the Nationa] Broadcasting Corporation, CBS Corporation, The Walt Disney Company, Time Warner Inc., The Washin�ton Post Company and Conde Nast Publications, Inc. — cable Internet access services offered by companies such as Excite@Home and Road Runner Group — Web sites focusin� on content, commerce, communiry and similar features such as Amazon.com and eBay • Competition in the development of distribution technoloaies and equipment includes: — broadband distribution technologies used in cable Internet access services offered by companies such as Excite cr Home and Road Runner Group — advanced telephone-based access services offered through di�ital subscriber line technolo�ies offered by local telecommunications companies — other advanced di�ital services offered by broadcast, satellite and wireless companies — television-based interactive computer services, such as those offered by Microsoft's WebTV — personal digital assistants or handheld computers, enhanced mobile phones and other equipment offerin� functional equivalents to the Company's features • Competitors in the development and sale of electronic commerce infrastructure and applications include: — providers of electronic commerce infrastructure such as server software, including International Business Machines Corporation, Microsoft Corporation, Oracle Corpomtion, Novell, Ine., Sofiivaze.com, Inc., BEA Systems, Inc. and the provider of the Apache Web Server — providers of electronic commerce applications includin� Intemational Business Machines Corporation, Oracle Corporation, General Elec[ric Information Systems, Microsoft Corporation, PeopleSoft, Inc., SAP A.G., Open Market, Inc., Ariba Technoloaies, Commerce0ne, Sterlin� Commerce, Inc. and BroadVision, Inc. Some of the present competitors and potential future competitors of the Company may have greater financial, technical, marketina or personnel resources than the Company. In addition, as a result of acquisitions, certain competitors are able to offer both lnternet access and other services, such as cable television or telephone service, and such consolidation may continue. The competitive environment could have a variety of adverse effects on the Company. For example, it could: • negatively impact the Company's ability to �enerate �reater revenues and profits from sources other than online service subscription revenues, such as advertisin� and electronic commerce • limit the Company's opportunities to enter into or renew agreements with content providers and distribution partners • limit the Company's abiliry to develop new producu and services Page 17 • li^-`' the Company's ability to continue to �row or sustain its subscriber base • require price reductions in the subscription fees for online s�rvices and require increased spending on mar�:etin�, nenvorl: capacity, content procurement and product and features developmenc • req�iire price reductions in the Company's enterprise sofiivare products • result in a loss of the Company's market share in the enterprise sof��•a;e indushy • require an increase in the Compan;�'s sales and marketing expendi� �res Any of the fore�oin� events couid have an adverse impact on r�venues or result in an increase in costs as a percentage oi revenues, either of �r•hich could have a material adv�rse effect on the Comoany's business, financizl condition and op°ratin� results. Consolidated Results of Operations Revenues The follo�ti�in� table and discussion highlights the revenues of tne Company for the years ended June 30, 1999, 1995 and 1997. Year ended Jtize 30, ----------------------------------------------- 1999 1998 1997 --------------- --------------- --------------- (Dollars in nillions) Revenues: Subscription services ................................... 53,321 69.5's 52,183 7o.6s $1,478 67.3°s Advertising, co�merce and other ......................... 1,000 21.o SS3 17.6 308 14.0 £nterprise solutions .................................... 456 9.5 365 1_.8 __ 411- 18.7 ------- ------- - ------ ------- ------- Total revenues......_.....••----••-•-•••••••-•••••••�� $4�� 100.0's $3,091 100.0's $2,197 100.0's The Company generates three main types of revenues: subscription services; advertisin�, commerce and other; and enterprise solutions revenues. Subscription services revenues are �enerated from customers subscribing to the Company's AOL service and, effective February 1, 1998, the CompuServe service. Advertisin„ commerce and other revenues are non- subscription based and aze �enerated mainly from businesses marketin� to the Company's base of Subscribers and users across its multiple brands. Advertisin„ commerce and other revenues mainly consist of advertisin� and related revenues, fees associated with electronic commerce and the sale of inerchandise. Encerprise solutions revenues consist principally of product licensin� fees and fees from technical support, consuitin� and trainin� services. Subscription Services Revenues Currently, the Company's Interactive Online Services business �enerates subscription services revenue primarily from subscribers payin� a monthly membership fee. Prio; to December l, 1996, a significant portion of online service revenues were comprised of hourly charges based on usage in excess of the number of hours of usage provided as part of the monthly fee. Nith the introduction of flat-rate pricing, as described below, the portion of online service revenues which are generated from hourly, charses has decreased substantially. Effective December 1, 1996, the Company be�an offerin� several pricin� alternatives to the AOL service in the U.S. aimed at providing a variery of price points designed to appeal to a wide ran�e of consumers. The Company's current pricin� options are as follows: � • A standard monthly membership fee of 521.95, with no additional hourly charges (the "Flat-Rate Plan"). Subscribers can also choose to prepay for one year in advance at the monthly rate of � 19.9�. The Company increased the price of its Flat-Rate Plan from 519.95 per month to 521.95 per month, and the effective monthly rate of the annual plan from $17.95 per month to $19.95 per month, efiective at the start of each members monthly billin� cycle in April 1998. Those subscribers who were currently on the annua] plan were not subject to an increase until their renewal date. These increases were implemented in order to fund the continued improvement of inembers' online experience and to keep pace with the cost to the Company of inembers' increased usaae. Page 18 • An altemative offerin� of three hours for 54.9� pz� month, with additional time �riced at S2.50 p�r hou;. • Ar� alternative offzring of �9.9� per month for unlimited use—for those subscribers who have an Intern�t conneccion other than throu�h AOL and use this connection to access AOL services. Prior to December 1, 1996, the Company's standard monthly membership fee for its AOL service in the U.S., which included five hours of service, ��ras 59.9� per month, «•ith a S2.9� hourly fee for usa�e in excess of five hotirs per month. Existin� members at December 1, 1996, could retain the �9.9� / five hour pricin� upon rzquest. For tne period July I, 1996 throu�h November 30, 1996, the Company also offered a pricin� plan �vhich included 20 hours of service for S 19.9� per month, with a�2.9� hourly fee for usa�e in excess of 20 hours per month (:he "Value Plan"). This plan «�as discontinued upon the availability of the Flat-Rate Plan on December 1, 1996. Effective February 1, 1998, the Company offered the following price plans for the CompuServe service: o A standard monthly membership offering of five hours for 59.95 per month, with additional time priced at �?.9� per hour. • An altemative offerin� of 524.9� per month ��'ith no additional hourly charge. During fiscal 1999, the Company launched CompuServe 2000 which utilizes the same platform and infrastructure as the AOL service. This service offered the followin� price plans: • A standard monthly membership offerin� of 20 hours for �9.95 per month, with additional time priced at 52.95 per hour. • An altemative offering of 519.9� per month with no additional hourly char�e. At June 30, 1999, the Company had approximately 17.6 million AOL brand subscribers, including approximately 15.� million in North America and approximately 2.1 million in the rest of the world. Also at that date, thz Company had approximately 2 million CompuServe brand subscribers, including approximately 1 million in North America and approximately 1 million in the rest of �vorld. At June 30, 1998, the Company had approximately 12.5 million AOL brand subscribers, includin� approximately 11.2 miUion in North America and approximately 13 million in the rest of the world. Also at that date, the Company had approximately 2 million CompuServe brand subscribers, including approximately 1 million in North America and approximately 1 million in the rest of world. For fiscal 1999, subscription services revenues increased from $2,183 million to 53,321 million, or 52%, over fiscal 1998. This increase was comprised of an increase in AOL subscription services revenues of 51,020 million, as well as CompuServe subscription services revenues of 5118 million, which be�an in February 1998. The increase in AOL subscription services revenues was primarily attributable to a 38% increase in the avera�e number of AOL North American subscribers for fisca] 1999, compared to fiscal 1998, as well as an 8.2% increase in the average monthly subscription services revenue per AOL North American subscriber. The avera�e monthly subscription services revenue per AOL North American subscriber increased from �17.95 in fiscal 1998 to �19.42 in fiscal 1999. This increase was principally amibutable to the increase in the Flat-Rate Plan membership fee from 519.9� to S21.95, which became effective in April 1998. For fiscal 1998, subscription services revenues increased from �1,478 million to $2,183 million, or 48%, over fiscal 1997. This increase was comprised of an increase in AOL subscription services revenues of 5637 million, as well as CompuServe subscription services revenues of $88 million, which began in February 1998, partially offset by a S20 million W� ris`� s subscription services revenues from the Company's Internet service, Global Netivork Navi�ator ('GNN"), discontinued in fiscal 1997. The increase in AOL subscription services revenues was primarily attributable to a 39% increase in the avera�e number of AOL North American subscribers for fiscal 1998, compared to fiscal 1997, as well as a 2.7% increase in the avera�e monthly subscription services revenue per AOL North American subscriber. The average monthly subscription services revenue per AOL North American subscriber increased from i17.48 in fiscal 1997 to 517.9� in fiscal 1995. This increase was principally amibutable to a reduction in the amount of refunds/crediu issued to subscribers in fiscal 1998. Page 19 Advertising, Commerce and Other Revenues An im�ortant component of the Company's business strate�y in its Interactive Online Services bt�siness is an increasin� reliance en adverisir.g, commerce and othe* revenues. T'hese revenues include advertisin� and electronic commerce fezs, the sale of inerchandise, as ��ell as other revenues, which consist primarily of royalry fees and development revenues, as �vell as data nehvork service revenues generated by ANS Communications, Inc. ("ANS") (through its sale ir. January 1998). The growth of advertisin„ commerce and other revenues is important to the Company's business objectives, as these revenues provide an important contribution to the Company's operatin� results. Advertisin� revenues are expected to �row in importance as the Company continues to ]evera�e its lar�e, active and �rowin� user base. This user base not only includes the payin� subscribers of the AOL and CompuServe services, it a]so includes users of the Company's other branded portals and services suc}� as AOL A4ovieFone, Netcenter (with more than 17 million re�istered users), AOL.COM, ICQ (with almost IS milfior. active re�istered use*s) and Di�ital City. Affecting the �rowth in advertisin�, commerce and other revenues is the backlo� balance as of June 30, 1999, 1998 and 1997 of �1,519 miliion, S�11 million and S180 million, respectively. During fiscal 2000, appro�imatel�� S680 million of revenues will be �enerated from the June 30, 1999 backlog. The followin� table summarizes the material components of advertising, commerce and other revenues for the years ended June 30, 1999, 1998 and 1997. Year er.den Juae 30, ----------------------------------------------- 1999 1998 1997 --------------- --------------- --------------- (Dollars in millions) Advertising and electzonic commerce fees....--•------••• S 765 76.5's $ 358 65.9% $ 147 57•7°s '•;=rchandise ............................................. 134 13.4 103 19.0 109 35.5 Other .............................••--.................. 101 10.1 82 15.1 52 16.9 ------- ------- ------- ------- ------- ------- ToCal advertising, conmerce and other revenues.......... $1,000 100.0% $ 543 100.0% $ 308 100.0% Advertisin„ commerce and other revenues increased by 84%, from 5�43 million in fiscal 1998 to $1,000 million in fiscal 1999. More advertisin� on the Company's AOL service and Netcenter portal, as well as an increase in electronic commerce fees drove the inerease. Advercisin� and electronic commerce fees increased by 114%, from 5353 million in fiscal 1998 to �765 million in fisca] 1999. AdveRising, commerce and other revenues increased by 76%, from 5308 million in fiscal 1997 to 5543 million in fiscal 1998_ More advertisin� on the Company's AOL service and Netcenter portal, as well as an increase in electronic commerce fees primarily drove the increase. Advertisin� and electronic commerce fees increased by 144%, from $147 million in fiscal 1997 to 53�8 rnillion in fiscal 1998. Enterprise Solutions Revenues The Netscape Enterprise Solutions business generates revenues that consist principally of product licensin� fees and fees from technical support, consultin� and trainina services. The Netscape Enterprise Group focuses on providin� businesses a range of software produets, technical support, consulting and training services. These products and services enable businesses and users to share information, mana�e nerivorks and facilitate electronic commerce on the Intemet. In November 1998, the Compahy entered into a strate;ic alliance with Sun Microsystems, Inc. ("Sun"), a leader in nerivork computin� products and services, to accelerate the growth of electronic commerce. The strate?ic alliance provides that, over a three year period, the Company will develop and market, to�ether with Sun, client software and network application and server software for electronic commerce, extended communities and connectiviry, includin� software based in part on the Netscape code base, on Sun code and technolo�y and on certain America Online services features, to business enterprises. Enterprise solutions revenues increased by 25%, from $355 million in fiscal 1998 to �456 million in fiscal 1999. The increase was due to an increase in product sales related to server applications and consultin� services coupled with the decline in revenues in fiscal 1998 due to offerin� the Netscape Communicator client software, includin� the Netscape Navi�ator browser for free starting in January 1998. Page 20 Enterprise solutions revenues decreased by ] 1%, from �411 mi[lion in fiscal I997 to 536� million in fiscal 1998. The decrease was due to offering the Netscape Communica!or client sofr�vare, includin� the I�etscape Navi�ator bro�vser for free startin� in January 1998, offse� by an 1 S% increase in product sales related to server applications and consulting services. Costs and Expenses The following table and discussion hi�hli�hts the costs and expenses of the Company for the years ended June 30, 1999, 199S and 1997. Year e7de3 June 30, ----------------------------------------------- 1999 1996 1997 --------------- --------------- --------------- (Dollars in millio:�s? Total revenues .......................................... 54,�� 100.Os $3,091 100.0's $2,197 100.0°s Costs and expenses: Cost of revenues ........................................ Sales and marketing Sales and marketing .................................. write-off of deferred subscriber acauisition cos:s... Product developmen: ....................................• General and admir.istrative .............•.•-•.••••-•••••• Amortization of goodwill and other intazgible assets.... Acquired in-pzocess research and develo�r.sent............ �ierger, restructuring and contract termination charges.. Settlenent charges ...................................... $2,657 55.6% $1,811 58.6% $1,162 808 16.9 623 20.2 608 _ _ _ - 385 286 6.0 239 7.7 195 408 8.5 328 10.6 2z� 65 1.4 24 0.8 6 _ - 94 3-0 9 95 2.0 75 2.4 73 _ - 17 0.5 25 52.9e 27 17 8 20 0 0 3 1 ------- ------- ------- ------- ------- ------- Total costs and expenses ........................•••-•••• 54,319 Cost of Revenues 90.5's $3,211 103.8% $2,682 122.1% Cost of revenues includes nehvork-related costs, consistin� primarily of data network costs, personnel and related costs associated with operatin� the data centers, data nenvork and providin� customer support, consultin�, technical support/trainin� and billin�, host computer and network equipment costs, the costs of inerchandise sold, royalties paid to information and service providers and royalties paid for licensed technolo�ies. Since the introduction of the FJat-Rate Plan for the AOL service in December 1996, the Company has experienced a si�nificant increase in both: 1) subscriber usage, which is mainly due to the growth of the subscriber base, and 2) the average monthly usa�e per subscriber as subscribers spend more and more time online. These increases have the potential to increase ne��ork cost on both an absolute dollar basis, as well as a percentaae of revenue basis. While the growth in subscriber usage and the related costs generally are consistent with the increases in subscription service revenues, the increase in usage and related cosu per subscriber could impact operatin� mar�ins. Average monthly subscriber usage in the first quarter of fiscal 1997, the last quarter before the introduction of flat-rate pricing, was approximately 7 hours. In fiscal 1998, average monthly subscriber usage ranged between 20 and 23 hours, and was approximately 22 houn in the fourth quarter of fiscal 1998. In fiscal 1999, averaae monthly subscriber usage ran;ed between 24 and 27 hours and was approximately 27 hours in the fourth quarter of fiscal 1994. The Company has, and plans to continue to minimize the impact of the aforementioned increases by increasing advertisin„ commerce and other revenues and by reducin� network costs, on a relative basis (either on a per-hour basis or as a percenta�e of total revenues). An important factor in reducing network costs is the reduction of the costs of operatin� the Company's data network, on a per-hour basis, throu�h volume discounts and more e�cient utilization of AOLnet, the Company's TCP/IP nenvork. The Company expecu that the gro�vth in advertisina, commerce and other revenues, assuming such �rowth continues, will provide the Company with the opportuniry and flexibiliry to fund the costs associated with the increased usa�e resultin� from flat-rate pricina, as well as programs designed to �row the subscriber base and meet other business objec[ives. For fiscal 1999, cost of revenues increased from $1,811 million to $2,657 million, or 47%, over fiscal 1998, and decreased as a percentage of total revenues from 58.6% to 55.6%. The increase in cost of revenues in fiscal 1999 was primarily amibutable to increases in data network costs, host computer and network equipment costs and personnel and related costs associated with operatin� the data centers, data network, providing customer support, consultin„ technical support/trainin� and billin�. Data nenvork costs inereased primarily as a result of the larger member base and more usage per member. Host computer and network Page 21 eqtiipment costs, consistin� of lease, depreciation and maintenance erpenses, increased as a result of additional host comouter and neRvork equipment, necessitatzd by the larger member base and more usage by memb�rs. Personnel and rzlated costs associated �vith operating the data centers, data nenvork, providin� cus[omer support and billing increased primariiy as a result of the requirements of supportin� a larger data ne�vork, a lar�er member base and increased subscription services r�venues. Personnel and ,related costs associated with consultin� and technical sttppo�Jtrair�in� increased due to providing �dditional customer support and professional services. The decrease in cost of revenues as a percenta�e of total revenues �ti�as primari(y attributable to �ro�vth of the hi�her margin adveRisin�, commerce and other rever,ues, as well as a decrease in nenvork-related costs as a percenta�e of subscription services revenue. For fiscal 1998, cost of reve�ues increased from 51,162 million to 51,811 million,.or �6%, over fisczl 1997, and increased as a percentage of total revenues from �2.9% to �5.6%. The i�lcrease in cost of revenues in fiscal 1998 ��'as primaril}' a�tributable to inereases in data nehvork costs, host computer and network equipment costs and personnel and related costs associzted with operating the data centers, data net�vork, providin� customer support, consultin�, technical supportJcrainin� and billin�. Data network costs increased primarily as a result of the lar�er member base and more usage per member. Host computer and nehvork equipment costs, consis[ing of lease, depreciation and maintenance expenses, increased as a result of additional host computer and network equipment, necessitated by the larger member base and more usa�e by members. Personnel and related costs associated with operatin� the data centers, data nenvork, providin� customer support and billin� increased primarily as a result of the requirements of supportin� a]ar�er data nenvork, a larger member base and increased subscrip[ion services revenues. Personnel and related costs associated «�ith consultin� and technical support/�rainin� increaszd due to providin� additional customer support and professional services. The increase in cost of revenues, as a percenta�e of total revenues, in fiscal 1998 was primarily attributable to an increase, as a percentage of total revenues, in host computer and net�vork eqt�ipment costs coupled with the decrease in revenues related to the hi�h mar�in Netscape Communicator client software (including the Netscape Navigator browser) partially offset by a decrease, as a percenta�e of total revenues, in royalties paid to information and service providers. Sales and Marketin; Sales and marketin� expenses include the costs to acquire and retain subscribers, the operating expenses associated �vith the sales and marketin� or�anizations and other �eneral marketing costs. Marketin� expenses have declined as a percentage of revenues primarily as a result of the improved value proposition offered by flat-rate pricing, which has resulted in improved subscriber acquisition and retention rates, as compared to rates achieved prior to flat-rate pricin�. The Company's marketin� strate�y is expected to continue to emphasize brand advertisin� across multiple brands as well as cost-effective bundlin� a�reements, where the Company's products are widely distributed with new personal computers, the Windo�ti�s operatin� system and other peripheral computer equipment and software. Additionally, the Company will continue to market its products via direct mail pro�rams. For fiscal 1999, sales and marketin� expenses increased from �623 million to 5808 million, or 30%, over fiscal 1993, and decreased as a percenta�e of total revenues from 20?% to 16.9%. The increase in sales and marketin� expenses for fiscal 1999 was mainly attributable to an increase in direct subscriber acquisition costs, brand advertisin� across multiple brands and personnel costs associated with expanding the Netscape Enterprise business. The decrease as a percenta�e of total revenues was primarily a result of the substantial ;rowth in revenues. For fiscal 1998, sales and marketing expenses increased from $608 million to �623 million, or 2%, over fiscal 1997, and decreased as a percenta�e of total revenues from 27.7% to 20.2%. The increase in sales and marketin� expenses for fiscal 1998 was mainly attributable to an increase in Netcenter staffn� and related sales commissions, partially offset by a decrease in subscriber acquisition costs. The decrease as a percentage of total revenues �vas mainly due to the decrease in subscriber acquisition costs. The Company made a chan�e in the first quarter of fiscal 1997 which resulted in subscriber acquisition costs bein� expensed for periods subsequent to the first quarter of fiscal ]997, versus bein� capitalized and amortized over hti•enty-four months in the first quarter of fiscal 1997 and prior. As a result of the aforementioned chan�e in accounting estimate, the balance of deferreo subscriber acquisition costs as of September 30, 1996, totalin� �385 million, was written off. For additional information re�arding this chan�e, refer to Note 3 of the Notes to Consolidated Financial Statements. For fisca! ]993, sales and marketin� expenses, before capitalization and amortization, decreased from $679 million to �623 milIion, or 8.2%, over fiscal 1997, and decreased as a percenta�e of total revenues from 30.9% to 20.2%. The decrease in sales Page 22 and marketin� expenses fo: fiscal 1995, before capitalization and amortization, �r•as primarily attributable to a decrease in subscriber acquisition costs. The Company was able to decrease its subscriber acquisition costs primarily as 2 result of the improved value proposition off red by flat-rate pricing, which has resulted in improved acquisition and retention rates, 2s compared to rates achieved p: ior to flat-rate pricin�. Product De�•elopment Product developm�n: costs consist of personnel and related costs for research and development efforts and other product development costs eith�r p: io' to the developtnent effo� reaching technological feasibility or once the product has reached the maintenance phase of its lif: c�cle. For fiscal 1999, .-o��::t e'=�'elopment costs inereased from �239 million to �?86 million, or 20%, over fiscal 1998, and decreased as a perce�ta�c ot co;�l revenues from 7.7% to 6.0%. The increase in product development cos[s was primarily due to an increzse in the numb:� o•` te:h ;iczl ernployees to support additional products across multiple brands. The decrzase in product development coscs �s : p: rc� �:;=_ z of total revenues was primarily a result of the substantial �rowth in revenues. For fiscal 199S. �'e::;�:t d=�'elopment costs increased from �19� million to �239 million, or 23%, over fiscal 1997, and decreased as a percer.ta=� of to;�l revenues from 8.9% to 7.7%. The increase in product development costs «�as primarily due to an increase in perso^n�l co;�s resultin� from the Company's acquisitions of Actra Business Systems LLC ("Actra"), KIVA Sofnvare Corpora;:on (� E:►�':��) and the online service of CompuServe (see Note 8 of the I�`otes to Consolidated Financial Statements). The c=:rc�s� i-: F:o�uct development costs as a percenta�e oftota] revenues was primarily a result of the substantial �rowth in revenues. General and Administrative For fiscal 19�9, :rn�r�l ar,� 2dminis[rative expenses increased from $328 million to �408 million, or 24%, over fiscal 1998, and decreased as a p::ce�ta;: o.` total revenues from 10.6% to 8.5%. The increase in general and administrative costs for fiscal 1999, ��'as primaril� �;t; ib:;ta51;: to higher personnel costs, including payroll taxes associated with employez stock option eaercises. The decrcas� i� �cneral and administrative costs as a percenta�e of total revenues was primarily attributable to the substantial growth in rcvcnu:s. For fiscal 199S. _en:ral and administrative expenses increased from $220 million to �328 million, or 49%, over fiscal 1997, and increased slightl� ss a�+:::enta�e of total revenues from 10.0% to 10_6%. The increase in ;eneral and administrative costs for fiscai 1998, and such cests as a percenta�e of tota] revenues, was primarily attributable to hi�her personnel and related costs, which included comp�nsa:o:�� stock options and other char�es primarily related to the sale of ANS, as well as increases in professional fees, prin:ipall}� related to le�al matters. Amortization of Goodwil! and Other Intanaible Assets Amortization of good�� ill and other intangible assets increased to �65 million in fiscal 1999 from $24 million in fisca] 1998 and S6 million in fiscal 1997. The increase in amortization expense over the three years is primarily aritibutable to goodwill associated with the acquisitions of Mirabilis, Ltd. ("Mirabilis") in June 1998, CompuServe in January 1998, DigitalStyle Corporation ("DigitalStyle") and Portola Communications, Inc. ("Portola") in June 1997, and Actra in December 1997, as ��ve11 �s purchases of various companies made by the Company in late fiscal 1997 and early fiscal 1998. The inerease is partially offsef by a decrease in goodwill amortization resulting from the disposition of ANS in January 1998 and the shutdo�m of GNN in the Company's fiscal ] 997 restructuring. Acquired In-Process Research and Development The Company incurred a total of S94 million in acquired in-process research and development charoes in fiscal 1998 related to the acquisitions of Mirabilis, Actra, Personal Library Software, Inc. ("PLS") and NetChannel, Inc. ("NetChannel"). In June 1998, the Company acquired the assets, including the developmental ICQ instant communications and chat technolo�y, and assumed certain liabilities of Mirabilis. The ICQ technolo�y is an enablin� technology for online communication. At the date of acquisition, Mirabilis reported 12 million registered trial users of which approximately half were active. The Company paid 5287 million in cash and may pay up to $120 million in additional contin�ent purchase payments Page 23 based on fiiture performance levels. The Company's Consolidated Stat�ments of Operations re;lect a one-time write-off of the amount of purchase price allocated to in-process research and deve!opment of approximately �60 million. The Company allocated the e�cess purchase price over the fair value of n�t tan�ible assets acquired to identified intan�ible assets. In p�rforming this allocatioa, the Company considered, among otner factors, the attrition rate of the ac[ive users of the technolo�y at the date of acquisition (estimated to be similar to the rate experienced by th� AOL service) and the research a�d development projects in-process a? the date of acquisition. With re�2rd to the in-process research and developmen[ projects, the Company considered, amon� other factors, the stage of development of each project at the time of acquisition, the importance of each projec[ to the overall development plan, and the projected incremental cash flo�vs from the proj�cts when completed and any associated risks. Associated risks include the inherent difficulties and unceRainties in compieting each project and thereby achieving technolo�ical feasibiliry and risks related to th� impact of potential chan�es in future tar�et markets. Durin� fiscal 1999, the Company incurred approximately �5 million, related primaril}� to salaries, to deveiop the in-process technolo�y into commercially viable products and the Company intends to incur approxi�nately �9 million more over the next year. Remaining development effo?ts are focused on addressin� security issues, architec[ure stabiliry and electronic commerce capabilities, and completion of these projects will be necessary before revenues are produced. The Conipany expects to be�in to benefit from the purchased in-process research and development by its fiscal year 2000. If these projects are not successfiilly developed, the Company ma}� not realize the value assi�ned to the in-process research and develop�ent projects. In addition, the value of the other acquired intangible assets may also become impaired. The Company acquired Actra, a developer of commerce applications for conducting business-to-business and business-to- consumer commerce on the Internet in December 1997, PLS, a developer of information indexin� and search technolo?ies in January 1998 and NetChannel, a Web-enhanced television company, in June 1995. These transactions were accounted for under the purchase method of accounting. In connection with the purchase of Actra, the Company recorded a char�e for acquired in- process research and development of �I4 million. In connection �vith the purchases of PLS and NetChannel, the Company recorded charges for acquired in-process research and development in fiscal 1998 of �10 million related to each acquisition. The Company incurted a total of $9 million (SS million and �4 miliion, respectively) in acquired in-process research and development char�es in fiscal 1997 related to the acquisitions of Portola and Di�italStyle in June 1997. The technology, market and development risk factors discussed above for the Mirabilis acquisition are also relevant and should be considered �vith re;ard to the acquisitions of Actra, PLS, NetChannel, Portola and Di�italSryle. Meraer, Restructuring and Contract Termination Charges In fiscal 1999, the Company recognized charges that totaled $95 million related to restructurings and mer�ers. In connection with the mer�ers of MovieFone, Inc., Spinner Net�vorks Incorporated, Nu1lSoft, Inc. and AtWeb, Inc. the Company recorded direct mer�er-retated costs of � 17 million. ln connection �vith plans announced and implemented in March 1999, the Company recorded a char�e of $78 million for direct costs related to the merger with Netscape and the Company's reorganization plans to integrate Netscape's operations and build on the scren�ths of the Netscape brand and capabilities as well az the mer�er with When, Inc. In fiscal 1998, the Company reco�nized net charges of �75 million re]ated to restructurin�s and mer�ers. In connection with a restructuring plan adopted in the third quarter of fiscal 1998, the Company recorded a$3� million restructurin; char�e associated with the restructurin� of its AOL Studios brand group. The restructurin� included the exitin� of ceRain business activities, the termination of approximately 160 employees and the shutdown of certain subsidiaries and facilities. At the end of the second and be�inning of the third quarters of fiscal 1998, the Company recorded a$35 million restrucNrin� charge related to the implementation of certain restructurin� actions mainly related to the Enterprise Solution business. These actions were aimed at reducing its cost structure, improving its competitiveness and restor:n� sustainable profitabiliry. The restructurin� plan resulted from decreased demand for certain Enterprise producu and the adoption of a new strate�ic direction. The restructurin� included a reduction in the workforce (approximately 400 employees), the closure of cercain facilities, the write-off of non-performin� operating assets and third-pariy royalry payment obli�ations relatin� to canceled contracts. Page 24 In the fiscat year ended 199S, the Company reco�nized mer�er costs of �6 million relaced to the acquisition of Kiva • Sofr��are Corporation, consistin� mainly of investment bankin�, le�al and ac�� nt�n� se;vices. • In connection with a restructurin� plan 2dohtihe1 Com any'sdchanger'of�fisiness9m7odele he�reor�anezat ond of ihe million restructurin� char�e associated �� P o the termination of approximately 300 employees and the shutdown of certatn Company into three operatin� units, operatin� divisions and subsidiaries. As of ersedlr�l�milleon of thelo9�n�alu estrutctur n�l,accrual in the first qua�rter`of had been completed and the Company rev fiscal 1998. In fiscai 1997, the Company reco�nized net charges of �73 mil�ior. rzlated to restructurings and co;�tract terminations. . In connection with a restructurin� plan adopt ihel Com an}'sdchange rin f business9modeIe he�reor�anizat o n of She million restructurin� char�e associated with P Company into three operatin� units, the termination of approximately 300 employees and the shutdown of cercain operatin� divisions and subsidiaries. • In the fouRh quarter of fiscal 1997, the Com hani �In a n a zrtain t nformation cp ov der �contrac'ts,R�whi h beca�me of unconditional payments associated uneconomic as a result of the Company's introduction of flat-rate pricin� in December 1996. Refer to Notes 4 and 5 of the Notes to Consolidated Financial Statements for furcher information related to the restructurin�s, contract terminations and mer�er costs. Settlement Charaes In fiscal 1998, the Company recorded 2 net sen lU S°Di hrct Counl fomthe East mnDistro t of Virhinia alle� ng�violatOns of v. America Online, Inc. class action lawsuit filed i federal securities laws benvezn Au�ust 199� and October 1996. Included in the net settlement charge is an estimate of �17 million in insurance receipts. ln fiscal 1997, the Company recorded a settlemen eoalrsettlementrreached w�h var ous cla slaction pla t ffse to resolve various State Attomeys General and a preliminary 1� potential claims arising out of the Company's introd ments �h Companyr a reed to make paymenu to subscribers,l accordin� unlimited access to subscribers. Pursuant to these settle , to their usage of the AOL service, who may have service reven es,tbutrare,ra her the compromase and settlement oflal eaat ons These payments do not represent refunds of onlin that the Company's advertisin� of unlimited accessli °estimat of theetotal�liabpiry assolcia ed wi h hesermatte sn and reversed second quarter of fiscal 1998, the Company revised S1 million of the ori�inal settlement accrual. Other Income, net Other income, net consists primarily of investment income and non-operating gains net of interest expense and non- o erating charges. The Company had other income of �638 miliionle to a30 m°ain of app oxima ely $567 mi 19on on the salelof p rimaril attributab a The increase in other income in fiscal 1999 was p Y Excite, Inc. investmenu. The additional increas�e Comi any had other in ome of $30 m'll on and $ 0 mi 1 on inlfiscal 1998 opentin� losses r e l a t e d t o v a r i o u s i n v e s t m e n t s P and fiscal 1997, respectively. The increase in other �n`erest income part$ally off etrbY dec ease b l en �e t allocation aof lossesato available-for-sale securities and increases in net m minoriry stockholders and increases in non-operatin� losses related to various investments. (Provision) Benefit for Income Taxes The (provision) benefit for income taxes was �(3'4 income tax s(in fiscal,1999 ista di ec99esult of the Company's inerease respectively. The substantial increase in the provision for Page 2� in pre-tax income. For additional information re�ardin� income taxes, refer to Note 14 of the i�Totes to Consolidated Financial Statements. Segment Re�ults of Operations The Company operates its nvo major lines of businesses zs Interactive Online Services and Enterprise Solutions. For further inforniation re�ardin� segments, refer to Note 9 of the Iv'otes to Consolidated Financiai Statzments. A summary of the segment financial information is as follows: Revenues: Interactive Online Services ................. Enterprise So2utions ........................ Total revenues .......................... income (loss) from operations: Interactive Online Services (1).(2)_........ Entezprise Solutions. (2)..----.--.•..••---• General & Administrative .................... Other (3) ....:.............................. Total income (loss) fron opezations..... Yezrs ea3ed June 30, ---------------------------------------- 1999 1995 1497 ------------ ------------ ------------ (Ano::zts in millioas) $5.32Z $2,726 51,786 456 365 411 ------------ ------------ ------------ $4,777 $3,091 $2,197 $ 955 $ 412 5 (257) 6 (18) 98 (408) (328) (220} (95) (186) f106) ------------ ------------ ------------ $ 458 $ i120) $ (485) (1) Loss from operations for the year ended June 1997 includes $385 nillioz c:rite-off o` ceferred subscribe= acquisition costs. (2) In fiscal 1999, Enterpzise Solutions and Interactive Oaline Services include $5 millioa and $60 nillion, respectively, of goodwill and other intangible assets a�ortization. (3) Othez consists of all soecial items; mezger, restructLZir.g, contract temination, acrnaired in-process research and development aad settlemer.t charges. For an overview of the se�ment revenues, refer to the consolidated results of operations discussion earlier in this section. Interactive Online Services income from operations increased from �128 million (excluding �35� million write-off of deferred subscriber acquisitions costs) in fiscal 1997 to �412 miilion in fiscal 1998 and 59�5 million in fiscal 1999. These increases are mainly the result of increases in subscription services and advertising, commerce and other revenues coupled with improved margins and a decrease in marketin� expenses (as a percenta�e of re�enues) resultin� from the improved value proposition offered by flat-rate pricin�. Enterprise Solutions income (loss) from operations decreased from $98 million in fiscal 1997 to a loss of $(18) million in fiscal 1998 and increased to income of $6 million in fiscal 1999. "I'he decrease from fiscal 1997 to 1998 was mainly a result of offering the Netscape Communicator client software (including the Netscape Navigator browser) for free starting in January 1998. The increase from fiscal 1998 to 1999 was mainly atttibutable to the increase in revenues. , Liquidity and Capital Resources The Company is currently financin� its operations primarily throu�h cash aenerated from operations. During fiscal 1999, the Company generated more than S 1 billion in cash from operations. In addition, the Company has generated cash from the sale of its capital stock, the sale of its convertible notes as well as the sale of marketable securities it held. T'he Company has financed its investments in telecommunications equipment principally through leasing. Net cash provided by operatin� activities was $1,099 million, $437 million and �131 million in fiscal 1999, 1998 and 1997, respectively, and increased primarily due to the Company's increase in net income. Net cash used in investin� activities was �1,776 million, �531 mi[lion and $367 million in fiscal 1999, fiscal 1998 and fiscal 1997, respectively. The increase in cash used in investin� activities is mainly due to the Company's $1.5 billion investment in a General Motors equity securiry related to the strategic alliance the Company entered with Hughes Electronics Corporation ("Hu�hes"). For additional information re�ardin� this investment, refer to Note 8 of the Notes to the Consolidated Financial Statements. The increase in cash used in investin� activities was offset by net proceeds of approximately $600 miltion related to the sale of Excite, Inc. investments durin� fiscal 1999. Net cash provided by financing Page 26 accivities was S887 million, 5�30 million and 5250 million in fiscal 1999, fiscal 1995 and fisc2l 1997, respectively. ]ncludcd in financing activities for the fiscal ]999, w'ere S»0 million in ag�regate net proceeds from a public stoci: ofFerin� of its common stock. i The Company uses its �vorking capital to finance on�oing opera:ions and to fund rtiarkecin� and tt�e development of its products and services. The Company plans to continue to invest in subscriber acquis:tion, retention and brand marketin� to expand its subscriber base, as well as in nenvork, computin� and support inirastructure. Additionally, the Company expects to use a portion of its cash for the acquisition and subs�quent fundin� of technolo�ies, content, prodticts or businesses complementary to the Company's current business. The Company anticipates that cash on hand and cash provided by operating activities will b� sufficient to fund its operations for the n�xt twelve montlls. The Company currently has approrimately 5��0 million available under a shelf registration filed in June 199S. In May 1999, ttie Company filed a registration statenent to raise an additional �4.5 billion by sale of the Company's debt securities, common stock, preferred stocl: depositary shares, warrants or stock purchase contracts to purchase common stock or preferred stock. The total offerin� price of these securities, in the a��re�ate, �vill not exceed S� biliion. At June 30, 1999, the Company had working capital of �2�4 million, compared to working capital of � l OS million at June 30, 1998. In addition, the Company had investments includin� available-for-sale securities of S2,1 � I million and �998 01�1 979 June 30, 1999 and ]998, respectively. Current assets increased by �716 million, from 51,263 million at June 30, , million at June 30, 1999, �}�hile current ]iabilities increased by ��70 million, from �1,1» million to �1,72� million, over this same period. The increase in current assets was primaril}� attributable to an increase in cash and short-term investments resultin� from cash �enerated by opzrations. Thz change in current liabilities �vas due to increases in other acerued expenses and liabilities, primarily related to an increase in accrued telecommunica[ions costs, as well an increase in deierred revenues. During July 1998, tne Company improved its cash and working capital balances as a result of a public offering of common stock. The Company sold 21,�60,000 shares of common stock and raised a total of �»0 million in new equiry which was used to fund general corporate purposes. In November 1997, the Company sold �350 million of 4% Convertible Subordinated Notes due November 15, 2002 (the "Notes"). The Notes are convertible into the Compan}� s common stock at a conversion rate of 76.637�2 shares of common stock for each �1,000 principal amount of the Notes (equivzlent to a conversion price of � I3.04844 per share), subject to adjustment in certain events. Interest on the Notes is payable semiannually on May 1� and November 15 of each year, commencin� on May 15, 1993. The Notes may be redeemed at the option of the Company on or after November 14, 2000, in whole or in part, at the redemption prices set fonh in the Notes. �. In June 1995, the Company purchased Mirabilis for �287 million in cash (and contin�ent purchase price payments of up to S 120 million) and NetChannel for S16 million in cash. For additional information re�arding thess acquisitions, see Note 8 of the Notes to Consolidated Financial Statements_ In 3anuary 1998, the Company consummated a Purchase and Sale A;reement (the "Purchase and Sale") by and amon� the Company, ANS Communications, Inc_ ("ANS"), a then wholly-owned subsidiary of the Company, and MCI WorldCom, Inc. ("WorldCom") pursuant to ��hich the Company transferred to WorldCom all of the issued and outstandin� capital stock of ANS in exchange for the online services business of CompuServe Corporation ("CompuServe"), which was acquired by MCI WorldCom shortly before the consummation of the Purchase and Sale, and �147 million in cash (excluding $IS million in cash received as paR of the CompuServe online services business and after purchase price adjustments made at closin�). Immediately after the consummation of the Purchase and Sale, the Company's European partner, Bertelsmann AG, paid $75 million to the Company for a 50% interest in a newly created joint venture to operate the CompuServe European online service. Each compan"y invested an additional �2� million in cash in this joint venture. The Company �enerated S?07 million in net cash as a result of the aforementioned transactions. The Company enters into multiple-year data communications agreements in order to support AOLne[. In connection with those a�reements, the Company may commit to purchase certain minimum data communications services. Should the Company not require the delivery of such minimums, the Company's per hour data communications costs may increase. For additional information reaardin; the Company's commitments, see Note 11 of the Notes to Consolidated Financial Statements. In May ]996, the Company entered into a joint venture �vith Mitsui � Co., ("Mitsui") and Nihon Keizai Shimbun, Inc. ("Nikkei") to offer interactive online services in Japan. In connection with the a�reement, the Company received approximately S28 miltion throu�h the sale of convertible preferred stock to Mitsui. The preferred stock had an a��re�ate liquidation preference of approximately 528 million and accrued dividends at a mte of 4% per annum. Accrued dividends could be paid in the form of Page 27 additional s' _. �s of preferzd stock. During May 199S, the preferre� stock, to�ether ��ith accrued but unpaid dividends, �ti�2s converted into 1,�65,000 shares of common stock based on �he fair market valtie of common stock at the time of conversion. The Cqmpany leases the majoriy of its equipmen: under non-cancelable operatin� leases. It is buildin� AOLnet, its data commun:cations nenvork, as well as expandin� its data center capaci[}�. The buildout of AOLnet and the expansion of data center capacity requires a substantial investment in telecommunications 2nd server equipment. The Company plans to continue making significant investments in these arezs. The Compar.}� is fundir.g these investments, which are anticip2ted to total approximately �1 billion in fiscal 2000, th;ou�h a combination of lezs�s, debt financin� and cash purchases. Earning.Before Interest, Taxes, Depreciation and Amortizati�n ("EBITDA") The following table zad discussion summarizes EBITDA for [he years ended June 30, 1999, 1998 and 1997: Years end°d June 30, ---------------------------------------- 1999 1998 1997 ------------ ------------ ------------ (Amounts in milliozs) zBITDA ...................................... 5958 5302 5111 The Company defines EBITDA as net income plus: (1) provision/(benefit) for income taxes, (2) interest expense, (3) depreciaiion and amoRization and (4) special charges. For the fiscai years ended June 30, 1997, EBITDA does not add back the amortization of subscriber acquisition costs. EBITD.A is presented and discussed because the Company considers EBITDA an important indicator of the operationa( stren�th and performance of its business includin� the ability to provide cash flows to service debt and fund capi[al expenditures. EBITDA, ho�vever, should noi be considered an alternative to operatin� or net income as an indicator of the performance of the Company, or as an alternative to cash flows from operatin� activities as a measure of liquidify, in each case determined ir. accordance with generally accepted accounting principles ("GAAP"). For fiscal 1999, EBITDA increased from �30? miflion to 5968 million or 221% over fiscal 1998. For fiscal 1998, EBITDA incre2sed from �111 million to 5302 million or 17?%. The increase from fiscal 1998 to 1999 is mainly due to the si�nificant increase in income before taxes (excluding special charges) from �96 million in fiscal 1998 to $649 million in ftscal 1999 as well as an inerease of approximately S] 00 million in depreciation and amortization. The increase from fiscal 1997 to 1998 is due� to the increase in income before taxes (excludin� special charges) from $16 million in fiscal 1997 to �96 million in fiscal 1998 as �vell as an increase of approximatel;� S100 million in depreciation and amortization. Seasonality The growth in subscriber acquisitions and usa�e in the Company's online services appears to be hiahest in the second and third fiscal quarters, when sales of new computers and computer software are hi�hest due to the holiday season and followin� the holiday season, when new computer and software owners are discoverin� Internet online services while spending more time indoors due to winter weather. Ho�vever, the Company does not definitively kno�v whether such increases in subscriber acquisitions and usa�e are primarily attributable to seasonal factors or to increased demand for Internet online services as a result of the growin� market demand and utility for such services. Since makin� advertisin� revenue a key component of the Company's strategy in its Interactive Online Services business, the Company has experienced difficulty in distinguishin� seasonality in advertising sales from the overall market arowth. Seasonal factors seem to be miti�ated by adveRisers' �ro�ving interest in the overall online medium as well as gainin� access to the Company's large and �rowin� subscriber/user base across mLltiple branded distribution channels. When the online advertisin� industry matures and online adveRisin� budgets experience normai growth, the Company expects to experience the effects of seasonality in securin� advertisin� commitments. Year 2000 Compliance The Company utilizes a si�nificant n�imber of computer software pro;rams 2nd operating systems across its entire organization, includin� applications used in operating iu online services and Web sites, the proprietary software of the AOL and CompuServe services, Netscape software products, member and customer services, network access, content providers, joint ventures and various administrative and billin� functions. To the extent that these applications contain source codes that are Page 28 unable to appropriately interpret the upcomin� calendar year 20�0, some l�vel of modificatior., or even possibly replacement may be necessary. , In 1997,;the Company appointed a Year 2000 Task Force to perfo*m an audit to assess the scope of the Compan��'s ris�s and bring its applications into compliance. This ?ask Fo:ce oversees testin� znd is continuing its assessmen± of the Comp2ny's compa�y-wide compliance. The Company's system hardware components, client and host soft�vare, current versions of Netscape soft�vare products and corpo-2te business and information systems are currently under�oing review and testin�. To date, the Company has experienced f:tv problems relzted to Yea: 2000 testin„ and the problems that have been identified are in the process of bein� addressed. The Company i�tends to make Year 2000 compliant certain v�rsions of the client sofrware for the AOL service and the ConzpuServe s�rvice that are available on the Windows and Macintosh operatin� systems, as well as versions of I�Tetscape soCt��•are products that are currently shipped. While the majoriry of AOL and CompuServe members iise propietary client soft�vare that �vill be compliant, a third-party internet brow•ser utilized in most versions of the client software may not be Year ?000 compliant. A free patch o; up;rad� will be required for members using some versions of the client software or bro�vQ`ad achieve Year 2000 compliance. In the coming months, the Company �vil] encourage members of its online services to up� their bro�vser and/or their sofiware to versions that are expected to be Year 2000 compliant, if they have not already done so. The Compan}� �vill make available to members, and communicate that availability, free patches or up�rades that can be do«•nloaded from the online services. The Company has not tested, and does not expect to certify as Year 2000 compliant, ceRain older versions of the AOL and CompuServe software. The Company has developed, and will be implementin� over the remainder of the year, a communication pro�ram that informs members how to obtain the free patch or up�rade to a Year 2000 compliant version of the client sofn�•are or browser. With respect to the Company's Netscape sofhvare business, testin� continues on currently shipped products. The Company also wiil make available, at no additional cost to customers, any required patch to the versions of Netscape sofnvare products currently bein� shipped to customers and communicate their availabiIiry. In addition, the Company will be encovragin� custo:ners to up�rade to versions of the softw�are that are expected to be Year 2000 compliant, if they have not already done so. In addition, the Company is continuin� to �ather information from its vendors, joint venture partners and content parmers about their pro�ress in identifyin� and addressing problems that their computer systems may face in correctly processin� date information related to the Year 2000. The Company intends to continue its efforts to seek reassurances regarding the Year 2000 compliance of vendors, joint venture paRners and content partners. In the event any third pariies cannot timely provide the Company with content, products, services or systems that meet the Year 2000 requirements, the content on the Company's services, access to the Company s services, the ability to offer products and services and the abiliry to process sales could be materially adverse]y affected. The costs incurred throu�h June 30, 1999 to address Year 2000 compliance �vere approximately �11 million. The Company currently estimates it will incur a tota] of approximately �20 million in costs to support its compliance initiatives. 'I'he Company cannot predict the outcome of its Year 2000 pro�ram, whether third party systems and component software are, or will be Year 2000 compliant, the costs required to address the Year 2000 issue, or whether a failure to achieve substantial Year 2000 compliance �vill have a material adverse effect on the Company's business, financial condition or results of operations. Failure to achieve Year 2000 compliance could result in some interrupcions in the work of some employees, the inabiliry of some members and customers to access the Company's online services and Web sites or errors and defects in the Netscape products. This, in turn, may result in the loss of subscription services revenue, advertising and commerce revenue or enterprise solution revenue, the inability to deliver minimum gua;anteed levels of traffic, diversion of development resources, or increased service and warranry costs. Occurrence of any of these may also result in additional remedial costs and dama�e to reputation. The Company has developed a contin�ency plan to address possible Year 2000 risks to its systems. The p]an identifies a hierarchy of critical functions, acceptable delay times, recovery strategies to reeurn funetions to operational status and defines the core team for mana�in� this recovery process. The Company wil! continue to modify this plan to address systems of its recent acquisitions. Inflation The Company believes that inflation has not had, and will not have in the future, a material effect on its results of operations. Page 29 Forrvard-I�ooking Statements This report and other oral and written stacements made by the Corrtpany to the public contain and incorporate by reference fonvard-lookip� statements ��ithin the meanin� of the "saf harbor" provisions of the Private Securities Liti�ation Reform Act of 99�. The fonvard-looking s:a:�meats are based on management's current expectations or beliefs and are st�bject to a number of factors and uncertzinties that could ca�ise actual results to differ materially from those dzscribed in the forward-lookin� statements. Such statements Zd�r�ss the followin� subjects: future operating resuits; subscriber �ro�vth and retention; advertising, commerce and other reven;��s: eamin�s �rowth and expectations; development and success of multiple brands; new products and services (such as AOL �.0, ::::1 the "You've Got Pictures," "My Calendar," AOL Search and AOL Plus features); corporate spendin�; liquidity; net��o;=: czpsciry; new access and distribt�tion technolo�ies; re�ulatory developments, includin� the Company's ability to shape �:::�::: policy in, for example, telecommunicztions, privacy and tax areas. The follo�vin� fz�to-s. ::�r�:�� o:hers, could cause actual results to differ materially from those described in the fonvard- looking statements: The risk th�� t::r C��-�.^�� and its data communications access providers will be unable to provide adequate server and nenvork capacit}•. i��s�.� zsso:i�ted with the fixed costs and minimum commitment nature of a substantial majority of the Company's net�+•o;F. s:-�::_s, such that a si�nificant decrease in demand for online services would not result in a. corresponding d�crc;:�: �. r._:�ti ork costs. Risks related to the build-out of AOLnet and the expansion of server and network capacity; the risE: ti�::: a:��:�-i� �vill not develop for the capaciry created; the risk that supply short2ges for hardrvare and equipment and fo; I.�:::: ��ci;�n�e carrier lines �from ]ocal telephone companies could impede the provision of adequate nen�•ork and s} stcm c: �::�� , ar.d the risk of the failure to obtain the necessary financin�. Any dam2�e o: f��::-; to the Company's computer equipment and the information stored in its data centers. Factors related to i-.:rtas�d competition, including: price reductions and increased spendin�; inability to �enerate �reater revenues and F-�:::s from advertisin� and electronic commerce; limitations on the Company's opportunities to enter into or renew a�recm;��s ��i;h content providers and distribution parmers; limitations on the Company's abiliry to develop new products and s:•n�c:s, limitations on the Company's ability to continue to grow or sustain its subscriber base; loss of the Company's mar}:ct s!;�-c in tne enterprise sofr�vare industry; and an adverse impact on �ross and operatin� margins. The failure tu incrr,:>; rc�•enues at a rate sufficient to offset the increase in data communications and equipment costs resulting from increasir� �sa�e. The risk of loss o.` s: r� ices of executive officers and other key employees. The risk that becaus: o.` seasonal and other factors, the Company is unable to predict growth in sales, usa�e, subscriber acquisitions and ad�•crtising commitments. The failure of the Company to establish new relationships with electronic commerce, advertising, marketin„ technology and content p;ovid�rs or the loss of a number of relationships with such providers or the risk of significantly increased costs or decreased revenues needed, to maintain, or resultin� from the failure to maintain, such relationships, as the case may be. � The risk associated ��ith acceptin� warrants in lieu of cash in certain electronic commerce agreements, as the value of such warrants is dependent upon the common stock price of the warrant issuer at the time the warrants are earned. The risks related to the acquisition of businesses, includin� the failure to successfully integrate and mana�e acquired technoloay, operations and personnel, the loss of key employees of the acquued companies and diversion of the Company's mana�ement's attention from other on;oin� business concems; and the risk of si�nificant charges for in-process research and development or other matters. The inability of the Company to introduce new producu and services; and its inability to develop, or achieve commercial acceptance for, these new products and services. The faiiure to resolve issues concernin� commercial activities via the Intemet, includin� securiry, reliability, cost, ease of use and access. The risk of adverse changes in the U.S. reoulatory environment surroundin� interactive services. Page 30 The failure of the Compan}� or its partners to successfully market, sell and deliver its services in intemational markets; and risks inherent in doin� business on an intzrnational levei, such as ]z�vs that differ greatiy from those in the United States, unexpecte�d chan�es in Tegulatoy requirements, political risks, export res~ictions and controls, tariffs and other trade barriers and fluctuations in currency exchan;e rates. The Company's inabiliry to offer its services through advanced distribution technologies such as cable and broadcast, and the resulting inability to ofier advanced services such as voice and full motion video. The Company's inabiliry to devefop r.e�v technology or modi� its existing technology to keep pace �vith technolo�ical advances and the pursuit of these technolo�ical advanczs requiring substantial expenditures. Item 7A. Quantitative and Qualitative Disclosures about 1Vlarl:et Risk The Company is exposed to immaterial levels of market risks, includin� changes in forzi�n currency exchan�e rates and interest rates. Market risk is the potential loss arising from adverse chan�es in market rates and prices, such as foreign currency exchan�e and interest rates. The Company does not enter inio derivatives or other financial instruments for tradin� or speculative purposes. The Company only enters into financia! instruments to mana�e and reduce the impact of changes in forei�n currency exchange rates. In June ]998, the Company initiated hed�in� activities to miti�ate the impact on intercompany balances of chan�es in forei�n exchangz rates. The Company is usin� forei�n currency fonvard exchan�e contracts as a vehicle for hed�ing these intercompany balances. A forei;n currency forward exchange contract obli�ates the Company to exchange predetermined amounts of specified forei�n currencies at specified exchange rates on specified dates and to make or receive an equivalent U.S. dollar payment equal to the value of such exchan�e. For these contracts that are designated and effective as hed�es, realized and unrealized gains and losses resultin� from chan�es in the spot exchange rate (including those from open, ma[ured and terminated contracts) are included in other income and net discounts or premiums (the difference between the spot exchan�e rate and the forward exchan�e rate at inception of the contract) are also accreted or amortized to other income, over the life of each conrract, usin� the strai�ht-line method. These gains and losses offset gains and losses on intercompany� balances, which are also included in other income. The related amounts due to or from counterpar[ies are included in other assets or other liabilities. 1n �eneral, these forei�n currency fonvard exchan�e contracts mature in three months or less. The estimated fair value of the contracts are immaterial due to their short-term nature. Item 8. Financial Statements and Supplementary Data Reference is made to the financial statements listed under the heading "(a) (1) Consolidated Financial Statements" of ltem 14 hereof, which financial statements are incorporated herein by reference in response to this Item 8. Item 9. Changes in and Disagreements �vith Accountants on Accounting and Financial Disclosure Not applicable. PART III Item 10. Directors and Executive Officers of the Registrant The response to this item is incorporated by reference from the Sections titled "Mana�ement" and "Section 16(a) Beneficial Ownership Reporting Compliance" in the Registrant's Proxy Statement for its 1999 Annual Meetin� of Stockholders. Item 11. Executive Compensation The response to this item is incorporated by reference from the Section titled "Executive Compensation;' but not from the Sections titled "Executive Compensation—Performance Graph" and "Executive Compensation—Report on Executive Compensation by the Compensation and Management Development Committee of the Board of Directors;' in the Re�istrant's Proxy Statement for its 1999 Annual Meeting of Stockholders. Item 12. Security Ownership of Certain Beneficial Owners and Management The response to this item is incorporated by reference from the Section titled "Share Ownership" in the Registrant's Proxy Statement for its 1999 Annual MeetinJ of Stocl:holders. Page 31 Item 13. Certain Relationships and Related Transactions The res�onse to this item is incorporated by reference from the Section titled "Certain Relationships and Related Transactions".in the Re�istrant's Proxy Statement for its 1999 Annual Meetin� of Stockholders. PART IV Item 14. Exhibits, Financial Statement Schedules and Reports on Form 8-K (a)(1) Consolidated Financial Statements The followin� consolidated financial statements ofAmerica Online, Inc. and the Repor of Independent Auditors thereon are included in Item 8 above: Consolidated Balance Sheets as of June 30, 1999 and 1998 ................................. F-2 Consolidated S�aGements of Operztions for the years ezded June 30, 1999, 199E, and 1997.. F-3 Consolidated SGacements of Char.ges in Stoc�choldezs' �quity for the years ended June 30, 1999, 1998, and 1997 ..................•••-•••••••........-••............._.....••••...... F-4 Consolida[.ed Statements of Cash Flows for the years e:�ded June 30, 1999, 1998, a�d 1997.. F-5 Notes to Consolidate3 Financial Statements ............................................... F-6 Report of Management ................................................•••-•••.....-••..._.. F-25 Report of Independent Auditors..••••••••••••••••.....••••-••••........-•••-...•••••...-•• F-2o (a)(2) Financial Statement Schedules Alt financial statement schedules required by Item 14(a) (2) have been omitted because they are inapplicable or because the required information has been included in the Consolidated Financial Statements or Notes thereto. (a)(3) Exhibits The followin� Exhibits are incorporated herein by reference or are filed with this repori as indicated below. Copies of exhibits wili be furnished, upon request, to holders or beneficial owners of America Online, Inc. Common Stock as of Au�ust 30, 1999, subject to payment in advance of a fee of 2� cents per pa�e to reimburse America Online, Inc. for reproduction costs. EXHIBIT LIST Exnibit No. Descrintion ------- --------------------------------------------------------------------------------------------------- 2.1 Purchase and Sale Agreement dated as of September 7, 1997 by and among America Online, Inc., ANS Communications, Inc. and WorldCom, Inc. (Filed as Exhibit 2 to the Comeany's Curzent Report on Forn 8-K, dated September 19,1997, and incozporaGed herein by reference.) 2.2 Agreement of Purchase and Sale dated as o_° June 5, 1998 by and among America Online, Inc., AOL Acquisition Cozp., R.G.A.O. Holdings Ltd., and Mirabilis, Ltd. and the Principal Stockholders (Confidential treatment has been requested with respect to certain portions of the Agreement)'.• (Filed as Exhibit 2 to the Company's Current Reoozt on Form B-K, dated June 11, 1998, and incorporated herein by reference.) 2_3 Agreement and Plan of Merger dated as of I3ovembez 23, 1998 by and among America Online, Inc., Apo110 Acquisition Corp. and Netscape Comnunications Corp�ration (Filed as Exhibit 2.1 to the Comoany's Current Report oa Form 8-K, dated November 23, 1998 and incoroora[ed hezein by reference.) 2.4 Agreement and Plan of Mergez dated as of Febzuary 1, 1999 by and among America Online, Znc., M? Acquisition Corporation and MovieFone, Inc. (Filed as Exhibit 2.1 to the Company's Current Report oa Form 8-K dated February 1, 1999 and incozporated herein by reference.) 3.1 Restated Ce:tificate of Incorporation of America Online, Znc. (Filed as Exhibit 3.1 to the Conpany's Annual Repozt on Form lo-K foz [he year en3ed June 30, 199� and incorporated herein by reference.) 3.2 A.�nendrent of Section A of Article 4 of the Restated Certificate of Incorporation o: Ame:ica Online, Inc. (Filed as Exhibit 3.1 to the Comoany's Quarterly Report on Fozm 20-Q for the quarter ended September 30, 1998 and incorporated herein by reference.) Page 32 3_3 Certificate of Designation, Pzeferences and Rights of S°ries A-: ^.io= ?articipating ?referred Stock o� Anerica Online, Inc. (Filed as Exhibit 3.3 to the Comoany's :+.^.�ual P.eaort oz Form l0-K fo: th2 year ended June 30, 1998 and incorpozated herein by reference.) 1 3.4 Cer�ificate o` Elinination of Series A Junior Pazticipation Prefe�red Stock of America Online, Inc. (Filed as Exhibit 3.4 to,Ghe Company's A�nual Report oa Fo.m 10-� for the year ended June 30, 199� and incorporated hezein by reference.? 3.5 Res:ated By-Laws oi lmerica Oaline, Inc. (Filed as Exhibit 3.5 to tne Cor.,oany's Annual Reoort on Form 10-K for the year e�ded June 30, 1998 and incorporated here�n by re�erer.ce.) 4.1 Ar[icle 4, P.rticle ' and Article 8 of the P.estated Certificate o° Zncorporation (see Exhibits 3.1 and 3.2) 4.2 Indenture, dated as of November 17, 1997 be�weer. America Online, Ir.c., as issuer, and State Street Bar_k and Trust Cozpany, as trustee. fFiled as Exhibit 4.1 to :he Comgany's Currea: Reoort on Forn 8- K, dated December 2, 1997 and incozporated herein by reference.) 5.3 Registration Rights Agreement, dated as of November 17, 1997 between America Online, Inc. an� Goldman, Sachs & Co., BT Alea. Brown Znco'rporated, Lehma� Bro�hezs Inc. a�d Cowen & Comnany. (Fi2ed as Exhibit E.2 to the Conaany's Current Report on Form S-K, date3 December 2, 1997 and incorporated herein by reference.) S.4 Purchase Agzeenent dated Novembez 12, 1997 between America Online, Zr.c. and Goldman, Sachs & Co., B2 Alex. Bro•.+a Zncorporated, Lehnan Brothers Inc. ar.d Cowe� & Comgaay. (Filed as Exhibit S.3 to th� Comnany's Cuzrent .°.e�ort on Form 8-K, dated Decembez 2, 1997 and incozporated herein by reference.) 4.5 Rights Agreement dated as of May 12, 1996, between Acnezica Or.line, Inc_ and SankBoston, h.A., as Rights Agent. (Filed as Exhibit 4.2 to the Company's Quarterly Report on Fozn 10-Q foz the auarter ended March 31, 1998 and incoroora:ed hereir. by reference.) 10.1 The Company's Enployee Stock Purchase Plar., as amended_ • 10.2 The Conpany's 1992 Employee, Director and Consultant Stock Optior. Plan, as amended. * 10.3 The Company's Incentive Stock Option Plan, 1987 Restatement. (Filed as Exk:ibit 10.25 to ihe Company's Registration Statenent on Form S-1, Registration Statement No. 33-45585, as filed on February 6, 1993 and incospozated hezein by zeference.) • 10.4 The Comoany's 196� Stock Incentive Plan. (Filed as Exhibit 10.26 to the Company's Registration Statement on Forn S-1, Registration Statement No. 33-45585, as filed on Febzuary 6, 1992 an3 incorporated hezein by reference.) 10.5 Amendment No. 1 to the Company's 1987 Stock Incentive Plan. (Filed as Exhibit 10.27 to the Comoany's RegisCration Scatement on Form S-1, Registzation Statement No 33-45585, as filed on February 6, 1992 and incorporated hezein by reference.) 10.6 Employment Agreemeat and related agreements entered into with Rober: W. Pittman. (Filed as Exhibit 10.15 [o the Conpany's Ar�nual Report on Form 10-K for the year ended June 30, 1997 and incozporated hezein by reference.) 10.7 Employment Agreer..ezt and zelated agzeements entered into with George Vzadenburg, III. (Filed as Exhibit 10.10 to the Conpany's Annual Report on Form 10-K for the year eaded June 30, 199E and incorporated herein by reference.) 10.8 Employment Agreenent and zelated agreements entered into with J. Michael Kelly. ' 10.9 Restricted Stock Agreement between America Online, Inc. and J. Michael Kelly (Filed as Exhibit 4.4 to the Company's Registration Statement on Form S-9, Registration S:atement No. 33-60623, as filed on August 4, 1998 and incozporated herein by reference.) 10.10 Strategic Develooment and Marketing Agreement made and entered into on November 23, 1998, by and between Amezica Online, Inc. and Sun Microsystems, Inc. (Confidential treatment granted) (Filed as Exhibi[ 10.1 to the Co�pany's Quarterly Report on Form 10-4 for the quazter ended Deceenber 31, 1998 and incozpozated hezein by zeference.) 10.11 Sun Miczosystems, Inc. Service Providez Agzeement effective November 1, 1998 (Gonfidential treatment gran�ed)(Filed as Exhibit 10.2 to the Comoany's Quarterly Report on Form 10-Q for quarter ended December 31, 1998 and incorporated hezein by reference.) Page 33 21.1 List of Subsidiaries � 23.1 Consent of Ernst & Young LLP � 24.1 �owers of Attorney * I * Filed with this report (b) Reports on Form 8-K The following reports on Form 8-K were filed during the quarter ended June 30, 1999: Item � Description Filin� Date --------- ------------------------------------------------------------------------------------------ ------------------ 5, 7 A report dated Apri! 21, 1999 filing a newsletter and his[orical unaudited Apri121, 1999 supplemental financial statements concerning certain one-time items 2, 7 An amendment to a prior report dated March l7, 1999 to file the financial April 21, 1999 statements of the Company, due to the acquisition of Netscape Communications Corporation 2, 5, 7 A report dated May 21, 1999 regardin� the acquisition of MovieFone, Inc. May 27, 1999 by the Company and liti�ation filed against the Company Page 34 SIGPIATURES Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the re�istrant has duly caused this report to be signed on its behalf by the undersi�ned; thereunto duly authorized, on the 13th day of Au�ust, 1999. AMERI E, NC. � BY= J. Michael Kelly, Senior Vice President, Chief Financia Officer and Assistant Secretary Pursuant to the requirements of the Securities Exchan�e Act of 1934, this report has been si�ned below by the followin; persons on behalf of the Re�istrant and in the capacities indicated on the 13th day of Au�ust, 1999. SiQnature Title Date Chairman of the Boazd, Chief Executive Ofticer Au�ust 13, 1999 Stephen M. Case (principal eaecutive ofiicer) President, Chief Operating Officer and Director August l3, ]999 R crt W. Pittman t�,'(ti l Senior Vice President, Chief Financial O�cer and Au�ust l3, 1999 J. Michael Kelt}� Assistant Secretary (principal financial officer) Vice President, Controller, Chief Accounting & Au�ust 13. 1999 James F. MacGuid�cin Budgct OfTcer (principal accovntin� officer) Daniel F. Akenon James L. Barksdale Frank 1. Cauficld Alcxander M. Haig, lr. William N. Melton Thoma� Middelhoff Colin L. Powell Franklin D. Raincs xBy' iC',f.� J. ichael Kelly, as Attorne in- Fact for each of the persons in cated Dirccror Dircctor Director Director Director Director Director Director Au�ust 13, 1999 Au�ust 13, 1999 August U', 1999 August 13, 1999 August 13, 1999 Auoust 13, 1999 August 13, 1999 August !3, 1999 AMERICA ONLINE, IIYC. II�TDEX TO COi�ISOLIDATED F1NA'fi'CIAL STATENIEI�TS Consolida�ed BalanCe Sheets as of Jun_ 30, 1999 azd 1998 ..................................... F-2 Consolidated Statements of O�era[ions for the years e:�3ad June 30, 1999, 1998 and 1997..__._. F-3 Consolidated StaGements of Changes in Stockholders' E�ity for tne years ended June 30, 1999, 1998 and 1997 ........................................................•••••••......_......._.. F-4 Consolidated StaGements oP Cash Flows for tne years er.3=d June 30, 1993, 1998 and 2997....... F-S Notes to Consolidated Financial Statenents ................................................... F-6 Report of Managenent ................................................••••••..:..........._.... F-25 Reoort of Independeat Auditors ............................................................... F-26 Page 36 AMERICA OlLI\'E, INC. CONSOLIDATED BALANCE SHEETS � ASSHTS Current assets: Cash and cash etiiva?^_�_s .....................••••..................._.......••-•--• Short-term inves�r..=-�: ...........................•••......................._........ Trade accour.:s re�e:�•ab'_e, '_ess allo:+ances o: S�� azd $34, respectively........ ..........................................._............_. Other receivables...... ........................ " .--."...... .................••-•... Prepaid expenses a::� ot.`.:: cc:reat assets ...............•••.......-••••••-••........ Total current asse�s ................................................................ Prooerty and equ:� _.._ at c�s�. n_t-•••• ............................................ Other assets: Investnents inc1��:-= �'=�-`-��'-°-for-sale securities ................................. Produc: develop-e^_ c��_s. -.__ ..................................................•-•- Good:+ill and o�re� :�_a-;:L:c assets, net ....................•-•••••.-...........-.. Otherassets.......... ................:......................_..._.........._ LIASILITIES AND STOC�C'iOLD�RS' EOUITY Current liabilities: Trade accounts paya5ie ....................................••••••..........._..•-••.- Other accrued exper.s^s a�= lia�:lities .............................................. Deferred revenue...... .............•••••--•••••-••••••••...............••••-- Accrued person:�el cos�s ....................._.....................................•- Deferred networR se-:ices c:e�?: .................................................... Total cuzrent liabilicie�........... ................................................ Long-term liabilities: Notes oayable........... ........................... ........................•-•....._ Deferred revenue....... ••'•" " " " " " " ""'" ..................................... Othez liabilities ................................•••••........................•••••• Deferred netwozk se�•ices c:e�ic ...............•••••••••••..............••-•••••-••- Total liabilities ................................................................... Stockholders' equicy: Preferred stock, 5.01 par value; 5,000,000 shares authorized, no shares issued and ouGStanding aL Ju�e 30, 1999 and 1996, respectively ........................... Common stock, S.O1 paz value; 1,800,000,000 shares authorized, 1,100,893,933 and 973,150,052 shares issued and outstanding at Jt:ae 30, 1999 and 1998, respectively. Additional paid-in capital ......................••......_..................._....... Accumulated comprehensive ir.come - unrealized gain on available-for-sale securi:ies, net ................................................ Retained earnings (accumula:ed deficit) ............................................. Total stockholders' e it •••••••-•••��" " " " " " " "'"'""'� 4u Y ...................... See accomparrying notes. Page 37 June 30, _- 1999 1998 -------- -------- (Anounts in nillions, exceot share data) $ 887 5 677 537 146 323 192 79 93 153 155 -------- -------- 1,979 1,263 657 503 2,151 531 100 8g 454 472 7 17 $5,348 $2,874 $ 75 $ 120 795 461 646 620 134 78 76 76 � -------- -------- 2,725 1,155 348 3�2 30 'I1 15 � 197 273 -------- -------- 2,315 1,878 11 10 2,703 1,431 168 145 151 (590) -------- -------- 3,033 996 -------- -------- $5,348 52.8�4 AMERICA ONLINE, INC. CONSOLIDATED STATEMENTS OF OPERATIONS Revenues: Subscription services ................................... Adver[ising, commerce and other ......................... Enterprise solutions .................................... Totalrevenues .........................••••••••••....... Costs and exoenses: Cost of zevenues ...................•-•-•••••-•-•........ Sales and marketing Sales and marketing .................................. Write-off of deferred subscriber acquisition costs... Product development ..................................... General and administrative .............................. Anortization of goodwill and other intangible assets.... Acquired in-process research and development............ Mezger, restruc[uring and conGract termination charges.. Settlemen[ charges ...................................... To[al costs and exoenses ................................ Income (loss) from operations ........................... Other income, net...........•••....--•••••-•........-... Income (loss) before provision for incone taxes......... (Provisioa) benefit for incone taxes .................... Net income f2oss) ...............••-••-•-•-•••••••-...... Earnings (loss) pez share: Earnings (loss) per share-diluted ....................... Earnings (loss) pez share-basic ......................... Weighted average shares outstanding-diluted ............. S,eighted average shares outstanding-basic ............... See accompanying notes. Pase 38 Year ended June 30, ------------------------ 1°95 1996 1997 ------- -------- ------- (�.:.oun�s in nillions, exceot per shaze data) $3;321 $2,183 $'_,4'78 1,000 543 308 456 365 411 ------- -------- ------- 4,777 3,091 2,197 2,657 1,811 1,162 &OS 623 608 _ - 385 286 239 195 �08 328 220 65 2S 6 - 94 9 95 75 73 - 17 24 ------- -------- ------- 4,319 3,211 2,682 e5g (120) (485) 638 30 10 ------- -------- ------- 1,096 (90) (475) (334) 16 (10) ------- -------- ------- $ 762 $ (74) S (485) $ 0.60 $(0.08) $(0.58) $ 0.73 $(0.08) $(0.58) 1.277 925 838 1,041 925 836 � F � a � � ir,: M Q � O x ►�+ U � �^ U� Z Z l�l /�^ Z v aZ zQ O � QU U �" .-. 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CONSOLTDATED STATEMEtiTS OP CASH FLOWS GasS flovs from ope:a:ir.g zc:ivities: I�:=: iRCO.^..2 �ZO55) .............."""""............ .................................. A3jus�r..ezts to zecon:ile r.e: ir.cor..e (loss) co net cas:� �:ovided by o�ezatir.g accivi:ies: F:i�e-o:f of de`ezred st:bscriber acc,uisicion coses ......:.........................:.... ��-cash res:suctu:ing cherges ......................................................... D=�reciation and a�o:tiza�iol .......................................................... A:.ar[ization of deferred ne:�:o-k se:vices credi� ....................................... Charge fo: zccsired in-process research aad developnen: ................................ Coaoezsa:ory seoc'r, op�io^s ...................•••••••................................... D�ferzed incone caxes .........................................................•••...... Gain on sale of investrzn:s ............................................................ AZOr[izatioa of subscrib�r acquisitio: cos[s ........................................... Changes in asse[s and lizSi2ities, net of the effeccs of acq�:isitions and dis�ositions: irada accoua�s receivable.•••••-•.......•••••-• ....................................•- O:her zeceivab?es.........•••......_.....•••........•••• ............................. Preeaid exoanses and o[hez c�zren� asse:s ............................................ Deferred sw'scsiber acquisicion costs ................................................ O�he_ asse:s ............................••-••.•••••-••............•--•............... Znvestments ineluding available-fo=-sale secuzi�ies .................................. Aecrued expenses and o[he= curzez[ liabilities ....................................... Deferzed revenue and o:her liabili[ies ............................................... Total a3justments ...................•-•......•••••••••••••••.......•••................. r�: cas.*. orovided by o?e:a�ing accivicies .............................................. Casa flovs fzon inves[ir.g ac[ivities: ?Lrehase o! propez�y and e�sior..ez: .....................•••••..................••••-.... ?roducc develoomeat coscs .............................................................. P:oceeds fro� sale o: iaves:r..eacs ...................................................... ?urchase of iavestments, includir.g available-fo:-sale securities ....................... :!atuzity of invescments....• ......................... .....•••••-•-•............._.. .... h�c (eaymencs) p:oceeds foz acquis?cioas/disposi[ions of subsidiaries .................. Othe: invescing ae[ivicies .....................................................•••••••- Ne: cash used in inves:i:g ac:ivities .................................................. Cash flovs from finar.ciny activi�ies: Proceeds froc issuance o: common ar.d preferred scock, net .............................. Proceeds frora sale and leaseback o` p:opercy and equipnen� ............................. ?:incioal an3 accrued in�eres� payr.ea[s on line of credit and debt ..................... P:oceeds froz line o= credie ar.d issuar.ce of deb: ...................................... he: cash provided by fina^cing ac�ivicies ........................•••••••••............. t:e: increase in cash and cash equivalencs .............................................. Cash and cash equivalencs a� beginnizg o_' year ......................................... Cash and cash eguivalencs at end of year ............................................... Year ended June 30, --------------------- 1959 1993 1997 ------ ------- ------ (A;.ou�[s in rillia:�s) $ 762 5 (74) S (485) - - 385 7 32 22 293 191 93 (76) f32} - - 9� 9 20 33 2 335 ('_d) (1) (564) (28) - - - 59 (123) 78 (122) 12 (67} 2 (63) 2'0 (SO) - - (130) S (5) (15) (16) (40) (30) 319 1+1 130 185 SOS 262 ------ ------- ------ 337 511 616 ------ ------- ------ 2,099 S37 131 (301) (38S) (230) (S9) (51) (5�) 769 67 26 (2,269) (166) (208) 133 303 83 30 (98) 30 (69) (22) ill) (1,776) (531) (367) B36 141 251 8 70 20 (22) (2) (22) 65 3�1 1 ------ ------- ------ 887 580 250 ------ ------- ------ 210 486 14 677 191 17? ------ ------- ------ S 887 5 677 5 191 Supplemental cash flov infozmation Cash paid during the yeas for: Ir.cezes�..._........•••••••••••-• ...........................•••-•...................... 5 17 5 10 S 2 See accompanying notes. Page 40 AMERICA ONLIhE, I�iC_ NOTES TO THE COPiSOLIDATED FI\AnCIAL :.. �-.TF.ME:�TS I�'ote 1. Organization America Online, Inc. (the "Company") was incorporated in the state of Dela�ti-are in May 198�. The Company, based in Dulles, Vir�inia, is the �vor]d's leader in interactive services, �Veb b*ands, Internet technologies and electronic commerce services. America Online, Inc. operates: nvo �vorldwide ln[emet services, the AOL service, �vith more than ] 7 million members, and the CompuServe service, �vitn approximatzly 2 million members; several leading Internet brands incl�iding ICQ, AOL Instant messen�er and Di�ital Ciry, Inc.; the Netscape Netcenter and AOL.COM Internet portals; the Netscape Communicator cli�nt softivare, including the Netscape T'avi�ator bro�vser; AOL ylovi°Fon�, the nation's number one movie listin� �uide and ticketin� service; and Spinner Nehvorks Incorporated and Nulisoft, Inc., leaders in Internet music. Throu�h its strategic alliance with Sun Microsystems, Inc., the Companv also develops and ofiers easy-to-deploy, end-to-end electronic commerce aad enterprise solutions for companies operatin� in and doin� business on the Internet. Note 2. Summar}' of Significant Accounting Policies Principles of Consolidation The consolidated financial statements include the accounts of the Company and its subsidiaries. All significant intercompany accounts and transactions have been eliminated. Business Combinations Business combinations �vhich have been accounted for under the purchase method of accountin� include the results of operations of the acquired business from the date of acquisition. Net assets of the companies acquired are recorded at their fair value to the Company at the date of acquisition. Amounts allocated to acquired in-process research and development are expensed in the period of acqtiisition (see I�'ote 8). Other business combinations have been accounted for under the poolin� of-interests method of accounting. In such cases, the assets, liabilities and stocl:holders' equity of the acquired entities were combined ��•ith the Company's respective accounts at recorded values. Prior period financial statements have been restated to �ive effect to the mer�er unless the effect of the business combination is not material to the financial statements of the Company (see Note 8). Revenue RecoDnition Subscription services revenues are recognized over the period that services are provided. Other revenues, which consist principally of electronic commerce and advertisin� revenues, enterprise solutions sales �vhich include sofnvare licenses and services, as ��ell as data neavork service rzvenues, are reco�nized as the services are performed or when the goods are delivered. Deferred revenue consisu primarily of prepaid electronic commerce and advertisin� fees and monthly and annual prepaid subscription fees billed in advance. , Be;innin� in fiscal 1993, the Company adopted Statement of Position 97-2 "Soft�vare Revenue Reco�ni[ion" as amended by Statement of Position 98-4. The effect of adoption did not have a material impact on the Company's results of operations. The Company recognizes the revenue allocable to sofnvare licenses upon delivery of the software product to the end-user, unless the fee is not fixed or determinable or collectibility is not probable. In sofnvare arrangements that include more than one element, the Company allocates the total arrangement fee amon� each deliverable based on the relative fair value of each of the deliverables determined based on vendor-specific objective evidence. Property and Equipment PropeRy and equipment are depreciated or amortized usina the strai�ht-line method over the following estimated useful lives: Compu:er equipment aad internal sofGware.. 2 to 5 years Buildings and related improvenents._...... 15 to 40 years Leasehold inprovements..•-.-•••-•-•-•••••- 4�0 10 years Furniture and fixtuzes .................... S years Effective July 1, 1998, the Company adopted Statement of Position (SOP) 98-1, "Accountin� for the Costs of Computer Software Developed or Obtained for Internal Use", which requires that certain cos[s for the development of intemal use software should be capitalized, includin� the cosu of codin„ sofrware confi�uration, up�rades and enhancements. The adoption of this pronouncement did not have a material effect on the Company's financial results. Subscriber Acquisition Costs and Advertising The Company accounts for subscriber acquisi[ion costs pursuant to Statement of Position 93-7, "Reporting on Advertising Costs" ("SOP 93-7"). As a result of the Company's change in accountin� Page 41 estimate (see i�Tote 3}, effective October 1, 1996, the Company began expensin� all costs of adveRisin� as incurred. Included in sales and marketin� expens� is both brand and acquisition advertisin� across the Company's mul:iple brands atld �vas 5�99 million, 5476 million and S4�3 million for the fiscal years ended June 30, 1999, 1995 and 1997, respectively. i Prior to October 1, 1996, tne Company accounted for the cost of direct response adverisin� as deferred subscriber acquisition costs to comply «'itn the criteria of SOP 93-7. These costs consist solely of the costs of marketing programs �vhich result in subscriber registra[ions without further effort rec�uired by the Company. Direct response advertisin� costs, relate directly to subscriber solicitations and principally include the printin�, production and shippin� of starter kits and the costs of obtainin� qualified prospects by vario�!s taroeted direct marketing pro�rams and from third parties. These subscriber acquisition costs have bezn incurred for the solicitation of specifically identifiable prospects. The deferred costs were amortized, beginning the month after such costs were inci�rred, o��er a period determined by calculatin� the ratio of current revenues related to direct response advertisin� vers�is the totai expected revenues related to this adveRisin�, or t�venty-four months, whichever was shorcer. All other costs related to the acquisition of subscribers, as well as general marketin� costs, were expensed as incurred. I�'o indirect costs are included in deferred subscrib:r acquisition costs. On a quarterly basis, m2nagement reviewed the estimated fiiture operatin� results of the Company's subscriber base in order to evaluate the recoverabifiry of deferred subscriber acquisition costs and the related amortization period. Management's assessment of the recoverabilit}� and amoRization period of deferred subscriber acquisition costs �vas subject to chan�e based upon actual results and oth°r factors. Product Development Costs The Company's subscription service is correprised of various features �vhich contribute to the overall functionatiry of the s�rvice. The overall functionalit}- of the service is delivered primarily throu�h the Company's four products (the AOL service and the CompuServe service for VVindows and Macintosh). The Company capitalizes costs incurred for the production of computer sofhvare used in the sale of its services. Capitalized costs include direct labor and related overhead for software produced by the Company and the cost of software purchased from third parties. A11 costs in the softwarz _ development process which are classified as research and development are expensed as incurred until technolo�ical feasibility has been established ("be[a"). Once technolo�ical feasibiliry has been established, such costs are c2pitalized until the sofnvare has completed betz testin� and is �enerally available. To the extent the Company retains the ri�hts to software development funded by third paries, such costs are capitalized in accordance ��ith the Company's normal accountin� policies. Amortization, a cost of revenue, is provided on a product-by-product basis, usin� the greater of the strai�ht-line method or the current year revenue as a percenta�e of total revenue escimates for the related software product, not to exceed five years, commencing the month afrer the date of product release. Qu2rterly, the Company reviews and expenses the unamortized cost of any feature identified as bein� impaired. The Company also reviews recoverability of the total unamortized cost of all features and softtivare producis in relation to estimated online service and relevant other revenues and, when necessary, makes an appropriate adjustment to net realizable va]ue. Capitalized product development costs consist of the follo�ving: Year ended June 30, (in nillions) 1999 1998 Balance, beginniag o: year.. 5 88 $73 Costs capitalized........... 45 51 Costs anoztized...........-• (33) (36) Balar.ce, ezd o` yea:........ $100 $88 The accumulated amortization of product development costs related to the production of computer sofnvare totaled �106 million and S72 million at Junz 30, 1999 and 1998, respectively. Based on the Company's product development process related to the Netscape Enterprise group, costs incurred benveen completion of the working model and the point at which the product is ready for �eneral release have been insi�nificant and have not been capitalized. Page 42 Included in product development costs are res�arch and develop:ner.t cos:s totalin� S179 mitlion, S1S2 million and 5139 million, and other product developme�t costs totalin� $107 miilion, ��7 million and S�6 million i� t}�e years ended June 30, 1999, 1993 and 1997, respectively. ` i Foreian Currency Translation and Hed�ing of Intercompan�� Balances Assets and liabiliti�s oi the Company's wholly-owned foreign subsidiaries are translated into U.S. dollars at year-end exchan�e rates, and revenu:s and expenses are translated at avera�e rates prevailin� durin� the year. Translation adjustments are inciuded as a component of stockt�olders' equiry. Forei�n currency transaction �ains and losses, which have been inmate;ial, zre included in results of operations. In June I99S, the Company initiated hed�in� activities to mitigate the impact o� intercompany balances of chan�es in forei�n exchan�e rates. In �eneral, these forei�n currency forward exchange contracts mzture in three months or less. The estimated fair value of the contracts is immaterial due to their short-term nature. Investments The Company has various investments, includin� fo,-ei�n and domestic joint ventures, that are accounted for under the equity method of accounting. All investments in �vhich the Company has the ability to exercise si�nificant influence over the investee, but less than a controllin� votin� interest, are accouated for under the equity method of accounting. Under the equity method of accountin�, the Company's share of the investee's earnings or loss is included in consolidated operatin� results. To date, the Company's basis and currznt commitments in its investments accounted for under the equity method of accounting have been minimal. As a result, these investments have not si�nificantIy impacted the Company's results of opera[ions or its financial position. All other investments, for which the Company does not have the abiliry to exercise si�nificant influence or for which there is not a readily determinable market value, are accounted for under the cost method of accountin�. Dividends and other distributions of earninos from investees, if any, are included in income �vhen declared. The Company p�riodically evaluates the carryin� value of its investments accounted for under the cost method of accountin� and as of June 30, 1999 and 1995, such investments w�ere recorded at the lower of cost or estimat�d net realizable value. Good�vill and Other Intanaible Assets Goodwill and other intan;ible assets relate to purchase transactions and are amortized on a sVai�ht-line basis over periods ranging from 2-10 years. As of June 30, 1999 and 1998, accumulated amortization was �89 million and �24 million, respectively. The Company periodically evaluates whether changes have occurred that would require revision of the remainin� estimated useful life of the assigned �oodwill or render the �oodwill noi recoverable. If such circumstances arise, the Company would use an estimate of the undiscounted value of expected future operating cash flo«�s. to determine �vhether the �oodwill is recoverable. Cash, Cash Equivalents and Short-term Investments The Company considers alI highly liquid investments with an ori�inal maturity of three months or less to be cash equivalents. Short-term investments of 5�37 million and $146 million as of the fiscal years ended June 30, 1999 and 199S, respectively, are carried at cost which approximates fair market value and mature within one year. Trade Accounts Receivables The carryin� arrzount o; the Company's trade accounts receivables approximate fair value. The Company recorded provisions of S33 and S25 million and �vrite-offs of �13 and �14 million durin� the fiscal years ended June 30, 1999 and 1998, respectively. Investments Including Available-For-Sale Securities The Company has classified all debt and equity securities �s available-for-sale. Available-for-sale securities are carried at fair value, with unrealized �ains and losses reported as a separate component of stockholders' equity net of applicable income taxes. Realized gains and losses and declines in value jud�ed to be other-than-temporary on available-for-sale securities are included in other income. The cost basis for realized gains and losses on availabie-for-sale securities is determined on a specific identification basis. As of June 30, 1999, the Company had available-for-sale equity investmenu in public companies with a fair market value of $1,956 million and a cost basis of $1,686 million. The unrealized gain of �168 million, net of tax, has been recorded as a sepante component of stocl:holders' equity. Included in the 51,956 million is an investment of �1.5 billion in a General Motors equity security related to the strategic alliance the Company entered with Hughes Electronics Corporation ("Hu�hes"). For additional information re�ardin� this investment, refer to Note 8. Durin; fiscal 1999, the Company sold investments in Excite, Inc. for a net aain of approximately $567 million. Page 43 As of Ju..� �0, 1998, the Corttpany iiad available-for-sale equity investments in public companies with a fair market vaIue o` S2S6 miilion and a cost basis of S�2 million. The unrealized �ain of �145 million, ne, of tax, has been recorded as a separate component of stockholders' eqni:y. Included in the �256 million is an investment in Excite, Inc. of �2�0 million. As of June 30, 1999, th: Company had approximately �12 million of d�bt securi[ies (inc(uded in investments includin� available-for-sale sec:�rities) �� i�h maturity dates in fiscal years 2002 and 2004. As of June 30, 1995, the Comp2ny had approximately ��7 millior. o` debt securities (included in investments includin� availablz-for-safe securities) with similar maturit}� periods. Tn� cost o; t:�es� debt securities approximated fair market value. In January 199i. t�: Sc:Lr:*.ies and Exchange Co:nmissio�� issued ne�v rules rzquirin� disclosu;e of the Company's accountin� polici�s f��- der��a:��:s and market risk discfosure. The Company does no? h2ve any material derivative financial instruments as of Jur.; 3U, 1 �?; .��d believes that the interest rate risk associated with its borro�vin�s and market risk associated with its available-for-s: l: sec�-i:i:s zre not material to the results of operations of the Company. The available-for-sale securities subject the Compar,�'� fin: n_�af ��sition to market rate risk. The Company sells products to customers in diversified industries, primarily in the Ar..;:i�a:. ti�,`i:h iacludes Canada and Latin America, Europe and the Asia Pacific re�ion. The Company performs on�oing c��:: c��l�:�:i��s of its customers' financial condition and generally does not require collateral on product sales. The Compa:�� r.��:-::s.::: r_serves to provide for estimated credit losses. Actual credit losses could differ from such estimates. Financial InstrutT�cnt� i:.c carryir.� amounts for the Company's cash and cash equivalents, other receivables, other assets, trade accounts p3�a:�:_, ::cr_:' expenses and liabilities and othe* liabilities approximate fair value. The fair marf:et value for notes payable (see ��.�:_ 1 ��:-.:: i�vestments including available-for-sale securities is based on quoted market prices where available. Barter Transa:tiunc lF.� Cornpany barters advercising for producis and services. Such transactions are recorded at the estimated fair va::;: of th; F�:. ��cts or services received or �iven. Revenue from barter transactions is reco�nized ��hen advertisin� is pro�•i�cd, and scnices received are char�ed to expense when used. Barter transactions are immaterial to the Company's statem�nt o; o� :ra��o�s for a!I periods presented. Net Income (Loss) per Common Share The Company calculates net income (loss) per share as required by SFAS No. 125, "Eamin�s per Sti�:e " S�?.� tio. 128 replaced the calculation of primary and fully diluted eamin�s per share with the basic and diluted eamin_s p�r s�: -c U�like primary earnin�s per share, basic earnin�s per share exclude any dilutive effect of stock options, �varrants an3 con�cr.�b:: securities (seeNote 7). � Stocl:-Based Cortipensation During 1997, the Company adopted SFAS No. 123, "Accountin� for Stock-Based Compensation." The p: o� isio�s of SFAS No. ]23 allow companies to either expense the estimated fair value of stock options or to continue to follo�� ttie int��r.si: value method set forth in APB Opinion 25, "Accountin� for Stock Issued to Employees" ("APB 25") but disclose the pro fo�rna effects on net income (loss) had the fair value of the options been expensed. The Company has elected to continue to z�pl� APB ?� in accountin� for its stock option incentive plans (see Note 16). Reclassification Cer,ain z.nounts in prior years' consolidated financiai statements have been reclassified to conform to the current year presentation. Use of Estimates The preparation of financial statements in conformity with generalty accepted accounting principles requires management to make estimates and assumptions that affect the amounts reported in the financial statements and accompanyin� notes. Actual results could differ from those estimates. Recent Pronouncements The FASB recently issued Statement No. 137, "Accountin� for Derivative Instruments and Hed�in� Activities-Deferral of Effective Date of FASB Statement No. 133". The Statement defers for one year the effective date of FASB Statement No. 133, "Accountin� for Derivative Instruments and Hedoin� Activities". The rule now will apply to all fiscal quarters of all fiscal years be�innin� after June 15, 2000. In June 1998, the FASB issued SFAS No. 133, "Accountin� for Derivative Instruments and Hed�in; Activities," which is required to be adopted in years beginning after June 15, 1999. Tne Statement permits early adoption as of the be�inning of any fiscal quarter after its issuance. The Statement will require the Company to reco�nize all derivatives on the balance sheet at fair value. Derivatives that are not hedges must be adjusted to fair value throu�h income. If the derivative is a hed�e, dependin� on the nature of the hedge, chan�es in the fair value of derivatives will either be offset a�ainst the change in fair value of the hedged assets, liabilities, or firm commitments throu�h earnin�s or recoonized in other comprehensive income until the hed�ed item is recognized in earnin�s. The ineffective portion of a Page 4� derivative's chan�e in fair value will be immediately reco�nized ia e2rnin�s. The Comp2ny has not yet determined if it will early adopt and �vhat the effect of SFAS No. 133 will be on the eamings and financial position of the Company. SOP 98-9, "Modification of SOP 97-2, Soit�vare Revenue Recognition, With Respect to Certain Transactions" was issued in �ecember 19�5 and addr�sses sofRVare revenue reco�nition as it applies to certain multiple-element arran�ements. SOP 98-9 also amends SOP 98-4, "Deferral of the Effective Date oi a Provision of SOP 97-2", to extend the deferral of application of certain passa�es of SOP 97-2 chrough fiscal years beginning on or before March 1�, 1999. All other provisions of SOP 98-9 are effective for transactions entered into in fiscal years be;innin� after March 1�, 1999. 7"he Company will comply with the requirements of this SOP as they become effective and this is not expected to have a material effect on the Company's revenues and earnin�s. Note 3. Change in Accounting Estimate As a result of a chan�e in accounting estimate, the Company recorded a char�e of S38� million (�0.46 per share), as of September 30, 1996, representing the balance of deferred subscriber acquisition costs as of that date. The Company previousIy had deferred the cost of certain marketin� activities, to comply �vith the criteria of Statement of Position 93-7, "Reportin� on Advertising Costs", and then amortized those costs over a period determined by calculatin� the ratio of current revenues related to direct response advertising versus the total expected revenues related to this adve;tisin„ or nvenry-four months, whiche�-er was shorter_ For further information on subscriber acquisition costs, refer to Note 2. The Company's chan�in� business model, �vhich includes flat-rate pricing for its online service, increasin�ly is.expecied to reduce its reliance on online service subscriber revenues for the �eneration of revenues and p:ofits. This changin� business model, coupled with a lack of historical experience with flat-rate pricing, created uncertainties re�ardin; the level of expected future economic benefits from online service subscriber revenues. As a result, the Company believed it no lon�er had an adequate accountin� basis to support reco�nizing deferred subscriber acquisition costs as an asset. Note 4. Merger/Restructuring Charges Durin� the quarter ended June 1999, the Company recorded a charge of approximately �1� million of direct costs primarily related to the mergers of MovieFone, Inc. ("MovieFone"), Spinner Networks Incorporated ("Spinner") and Nul]Soft, Ine. "NullSoft"). These charaes primarily consisted of investment banker fees, severance and other personnel costs, fees for le�al and accounting services, and other expenses directly related to the transaction. �. During the quarter ended March 1999, the Company recorded a charae of approximately �78 million of direc[ costs primarily related to the mer�ers of Netscape and When, Inc. and the Company's reor�anization plans to integrate Netscape's operations and build on the strenaths of the Netscape brand and capabilities. This char�e primarily consists of investment bant:er fees, severance and other personne] costs (related to the elimination of approximately 8�0 positions), fees for le�al and accountin� services, and other expenses directly related to the transaction. Durin� the quarter ended December ]998, the Company reco�nized approximately �2 million in mer�er related costs in connection with the merger of AtWeb, Inc. These expenses were primarily associated with fees for investment banl:in;, le�al and accountina services, severance costs and other related charges in connection with the transaction. The followin� table summarizes the activity in the 1999 accruals durin� the period ended June 30, 1999. The balance of the restructuring acerual at June 30, 1999 is included in other accrued expenses and liabilities on the consolidated balance sheet and is anticipated to be paid within 12 months. (in millions) Restructuringf Salance Merger Non Cash June 30, Charges Itens Payments 1999 ------------- -------- -------- -------- Sanking, legal, regulatory and accounting fees........... 549 S- S(45) $ S Severance and related costs..... 2� - (16) 11 Facilities shutdown costs....... 9 - (1) e Miscellaneous expenses.......... l0 -__-_(7) __-__(6) _-_(3)-_ Total ....................••••... -----$95----- 5 f7) Sf68) 520 Page 45 In connection with a restructurin� plan adopted in the third qu2rter of fiscal 1995, the Company recorded a S35 million restructuring char�e associat�d with the restructuring of its former AOL Studios brand group. The restructurin� inci�ided the exitin� of cartain business activities, the tem�ination of approximately 160 employees and the shutdo�vn oi certain subsidiaries and facilities. Durin� fiscal 199S, the Company recorded a�35 million restructurin� char�e associated �z�ith actions aimed at rzdiicin� its cost structure, improvin� it� competi[iveness and restorin� sustainahle profitabi[it}� mainly related to the Netscape Enterprisz ;roup. The restructurin� plan resulted from decreased demand for certain Netscape products and the adoption of a new strate�ic direction. The restruc�urin� included a reduction in the workforce (approtimately 400 employees), the closure of certain f2cilities, the �vrite-off of non-performin� operating assets, and third-pzrty royalty payment obli�ations relatin� to canceled contracts. As of June 30, 1999, all of the restructuring activities related to fiscal 1995 has been completed. In connection with a restructuring plan adopted in the second quarter of fiscal 1997, the Company recorded a$49 million restructurin� char�e associated with the Company's chan�e in business model, the reor�anization of the Company into three operatin� units, the temiination of approximately 300 employees and the shutdown of certain operatin� divisions and subsidiaries. As of September 30, 1997, al] of the restructuring activities had been completed and, as a result, the Company reversed �1 miliion of the ori�inal restructuring accrual. Note 5. Contract Termination Charee In fiscal 1997, the Company recorded a contract termination charge of �24 million, which consisted of unconditional payments associated with terminatin� certain information provider contracts, which became uneconomic as 2 result of the Company's introduction of flat-rate pricin� in December 1996. Subsequent to the contract terminations, the Company entered into new agreements with these information providers. Note 6. Settlement Charges In fiscal 1995, the Company recorded a net settlement char�e of �18 million in connection �vith the settlement of the Orman v. America Online, Ine., class action lawsuit filed in the U.S. District Court for the Eastern District of VirDinia alle�in� violations of federal securities la��s benveen Au�ust 1995 and October 1996. As of June 30, 1999; the Company has paid out approximately �35 million and has a receivable of �17 million related io the estimated insurance receipts in other receivables. In fiscal 1997, the Company recorded a settlement char�e of S24 million in connection �rith a legal settlement reached with various State Attomeys General and a preliminary le�al settlement reached with various class action plaintiffs, to resolve potential claims arisin� out of the Company's introduction of flat-rate pricing and its representation that it �vould provide unlimited access to its subscribers. Pursuant to these settlements, the Company a�reed to make payments to subscribers, according to their usa�e of the AOL service, who may have been injured by their reliance on the Company's claim of un]imited access. These payments do not represent refunds of online service revenues, but are rather the compromise and settlement of allegations that the Company's advertisin� of unlimited access under its flat-rate plan violated consumer protection laws. In fiscal 1998, the Company revised its estimate of the total liabiliry associated with these matters and reversed,$1 million of the or:�inal settlement accrual. Page 46 Note 7. Earnings (Loss} Per Share The folloivin� table sets forth the computation of basic and diluted eamings (loss) per share for the years ended June 30, 999, 1998 and 1997: (in millions except for p°r snare data) 1999 1998 1997 Basic earninas a>r sha:e: Ivet income (loss) available to commo:� share:�olders ..............................5 762 S (74) S(465) -------- -------- -------- weighted average shares outs[anding.........-•••••-•-•••••••••-••••••••••••••••• 1,041 9z� 83$ Basic earnings (loss) per share....--•••••• .....................................5 0.73 S(0.08) S(o.5s) Diluted earnin4s oer share: Net income (loss) available to common shareholders .....................••.•-•-••S 762 $ (74) $(485) Interest on convertible debt, net of tax ........................................ 10 - ' -------- -------- -------- Adjusted net income (loss) available to conmon shareholders . . ................ 772 $ �74) $ (485) assuming conversion .......................................... S -------- -------- -------- weighted average shares outstanding ............................................. 1,oa1 925 838 Effect of dilutive securities: Employee stock options ...........................•••..........-••............ 191 - - warrants..................................................................... 20 - - Coavertibledebt ....................................................•••••••.. 25 - - -------- -------- -------- Adjus[ed weighted average shares and assumed conversions ........................_-1,277- --_-925- 838 -------- -------- --- • .............................••... 0.60 S (0.08) S (0.58) Diluted earnings (loss) per share ............. $ Note 8. Business Developments Purchase Transactions Acqtcisition ofMirabilis, L�d. In June 1998, the Company purchased the assets, includin� the developmental ICQ instant communications and chat technolooy, and assumed certain liabili[ies of Mirabilis, Ltd. (' i�Iirabilis") for 5287 million in cash. Mirabilis was a development sta�e enterprise that had generated no revenues. In addition, contin�ent purchase payments, based on future performance levels, of up to �120 million may be made over three years be�innin� in the Company's fiscal year 2001. The acquisition was accounted for under the purchase method of accountin� and, accordin�ly, the results of operations are included in the financial statemenu as of the date of acquisition, and the assets and liabilities were recorded based upon their fair values at the date of acquisition. The Company has allocated the excess purchase price over the fair value of net tan�ible assets acquired to the following identifiable intangible assets: goodwill and strategic value, existing technolo�y, base of trial users, ICQ vadename and brand and acquired in- process research and development. In connection with the acquisition of Mirabilis, the Company recorded approximately $228 million in goodwill and other intan�ible assets, which aze bein� amortized on a strai�ht-line basis over periods of five to ten years. Acquisition of Comp:rServe Online Services B:�siness In January 1998, the Company consummated a Purchase and Sale A�reement (the "Purchase and Sale") by and amon� the Company, ANS Communications, Inc. ("ANS"), a then wholly-owned subsidiary of the Company, and MCI WorldCom, Inc. ("WorldCom") pursuant to which the Company transferred to WorldCom all of the issued and outstandin' capital stock of ANS n exchange for the online services business of CompuServe Corporation ("CompuServe"), which was acquired by WorldCom shortly before the consummation of the Purchase and Sale, and $147 million in cash (excluding $15 million in cash received as part of the CompuServe online services business and after purchase price adjustments made at closin�). The transaction �va� Page 47 accounted f�r under the purchase method of accountin� and, 2ccordin�ly, tne assets 2nd liabili:ies were recorded based upoa their fair values at tne date of acquisicion. As a result of these transactions, the e�cess of the cash and the fair value of th: CompuServe business received over the book value of ANS amounted to S3S 1 million. This balance is classi ied as ciirrent and lon� term d,eferred nenvorl: services credit znd is being amorized on a strai�ht-]ine basis over a five-year term (equal to the term of a nenvork services agreement entered into with WorldCom) as a reduction of ne�vork services expense within cost o; revenues. In connection with the acquisition of CompuServe, tne Comp�ny rzcorded approximately �12i million in �ood�vill and other intan�ible assets, which are bein� amortized on a straight-line basis over p�riods ofthree to seven years. Immediately after th� consummation of the Purchase and Sale, the Compzn}•'s European partner, Bertelsmann AG, paid �7� million to the Company for a 50% interest in a newly crzated joint venture to operate the CompuServe European online s°CV1C2. Both the Company and Bertelsmann AG im�es[ed an additionzl �2� million in cash in this joint venti:re. The Company accounts for this transaction under the eqvity metnod of accounting in accordance ��ith the terms of the securities issued in the joint ventvre. Other P:rrchase Transac�ions In fiscal 1998, the Company acquired Personal Librzry Sofhvare, Inc. ("PLS"), a developer of information indexin� and search technolo�ies, NetChannel, Ine. ("I�TetChannel"), a�Veb-enhanced television compan}� and the remainin� equiry inter�sts of Actra Business Systems LLC ("Actra"), a desi�ner of Intemet commerce applications. The Company purchased all o; tne outstanding capital stock of each of the corporations and the ]imited liabiliry compan}� and assumed all oi their oLtstanding stoc�: options in exchan�e for an a„re�ate o; approximately 3.3 million shares of the Company's common stock and options, approximately �16 million in cash payments, the zssump:ion of approzimately S21 million in Iiabilities and S2 million in transition costs. The totat purchase price for these transactions was approtimately �] 14 million. In fiscal 1997, the Company acquired Portola Communications, Inc. ("Portola"), a builder of hi�h-performance messaging systems, DigitalStyle Corporation ("DigitalSryle"), a developer of Web graphics tools and Java-based animation and tne ImagiNation Network, Inc. ("INN"), an interactive �ames company. The Company purchased all of the outstandin� capital stock of each of the corporations 2nd assumed alI of their outstandin� stock options in exchan�e for an a�gre;ate of approximately 4.7 million shares of the Company's common stock and options and approxima:ely S3 million in transition costs. The purchase price for the acquisi[ions was approximately 576 million. In connection with the above mentioned purchase transactions, the Company recorded charges for acquired in-process research and development ("IPR&D") of approximately 59=1 million in the fiscaI year ended June 30, 1998 and approximately S9 million in the fiscal year ended June 30, 1997. Any rel2ted purchased IPR�:D for each of the above acquisitions represents the present value of the estimated after-tax cash flows expected to be �enerated by the purchased technology, which, at the acquisition dates, had not yet reached technolo�ical feasibiliry. The cash flo�v projections for revenues were based on estimates of relevant market sizes and �rowth factors, expzcted industry trends, the anticipated nature and timing of new product introductions by the Company and its competitors, individual product sales cycles and the estimated life of each product's underlying technology. Estimated operating expenses and income taxes �vere deducted from estimated revenue projections to arrive at estimated after-tax cash flows. Projected operatin� expenses include cost of goods sold, marketing and sellin� expenses, general and administrative expenses, and research and development, includin� estimated costs to maintain the producu onc� they have been introduced into the market and are �enerating revenue. The remaining identified intan�ibles, includin� �oodwill that may result from any future contin�ent purchase payments, «•ill be amortized on a straight-line basis over lives ran�in� from 5 to 10 years. The followina unaudited pro forma information has been prepared assumin� that the sale of ANS and the acquisitions of Portola, DigitalSryle, Actra, CompuServe and Mirabilis had taken place at the be�inning of the respective periods presented. The amount of the ag�regate purchase price allocated to acquired IPR&D for each applicable acquisition has been excluded from the pro forma information, as it is a non-recurrin� item. The pro forma financial information is not necessarily indicative of the combined results that �vould have occurred had the acquisitions taken place at the be�innin� of the period, nor is it necessarily indicative of results that may occur in the futurz. The proforma effect of the PLS, NetChannel and INN transactions are immaterial for all periods presented and therefore are not included in the pro forma information. Page 48 ?ro Forma Fo: the year er.de3 June 30, i (ir. millions, except per snaze data) 1998 (ulaudited) P.evenue ............................. 53.229 Loss from operations ................ 5(5?) N=t Loss ..................•••••..... 5(11) Loss per sYare-diluted .............. ' S(o.ol) Loss per share-basic ................ 5(0.01) Pooling Transactions In March 1999, the Company completed its merger �vith Netscape Communicacions Co:�oration ("Netscape"), in which Netscape became a whol!}�-o�med subsidiary of the Company. The Company exchan�ed approximately 9� million shares of common stock for all the outstandin� common shares of Netscape. The merger was accounted for under the poolin; of-interests method of accounting and, accordingly, the accompanyin� financial statements and footnotes have been restated to include the operations of Netscape for all periods presented. Durin� the quarter ended March 31, 1999, the Company incurred approximately �25 million in transition and retention costs, �vhich was char;ed to operatioas as incurred. For tne years ended June 30, 1999 (through the date of the mer�er), 1998 and 1997, Neucape's revenues ��•ere approximately �461 million, $452 miilion and S461 million, respec[ively. For the years ended June 30, 1999 (throu�h the date o: the merger), 1998 and 1997, Neucape's net income (loss) was approximately �(77) million, �(1�9) million and S14 million, respectively. See Note 4 for additional information. Durin� fiscal 1999, the Company completed mer�ers with Nullsofc, Inc. ("Nullsof") and Spinner Nehvorks Incorporated ("Spinner"), companies that provide Intemet music, When, Inc. ("When.com"), a company that provides a personalized event directory and calendar services, AtWeb, Inc. ("AtWeb") and PersonaLo�ic, Inc. ("PersonaLogic"). The Company exchan�ed approximately 8.2 million shares of common stock for all the outstanding capital stock of these companies. These mer�ers were accounted for under the poolin� of-interests method of accountin�. As the combined results o; these companies is material to the Company's net income (loss) for the fiscal year ended June 30, ]998, the accompanying financizl statements have been restated to include the operations of these companies for all periods presented. For the year ended June 30, ]999, these companies had revenues of approximately S2 million through the date of the mer�er and all prior years were immaterial. For the years ended June 30, 1999 (throu�h the dates of the mer�ers), 1998 and 1997, the net loss for these companies was approximately �18 million, $8 million and S3 million, respectively. See Note 4 for additiona] information. In May 1999, the Company completed its mer�er ��•ith MovieFone, Inc., ("�IovieFon� '). The Company exchan�ed approximately 4.3 million shares of common stock for ali the ou�standing common and preferred shares of MovieFone. As MovieFone's historical results of operations were not material in relation to those of AOL, the financial information prior to the quaner ended June 30, 1999 has not been restated to reflect the merger_ See Note 4 for additional information. In December 1997, the Company completed iu merger with KIVA Softtivare Corporation ("KIVA"). The Company exchanaed approximately 5.4 million shares of common stock for all of the ouutandin; capital stock and options of KIVA, a privately held company. The merger was treated as a poolin� of-interests for accounting purposes, and accordin�ly the historical• financial statements of the Company have been restated as if the merger occurred at the be�innin� of the earliest period presented. ln connection with the business combination, the Company incurred direct transaction costs of approximately $6 million, which consisted primarily of fees for investment banl:in„ leoal and accountin� services incurred in conjunction with the business combination. For the years ended June 30, I998 (throuoh the date of the mer�er) and 1997, KIVA's revenues were approximately S4 million and $1 million, respectively. For the years ended June 30, 1998 (through the date of the merger) and 1997, KIVA's ne[ loss was approximately $3 million and $� million, respectively. Other Business Developments In June 1999, the Company announced a strategic alliance with Hughes Electronics Corporation ("Hu�hes") to develop and market uniquely inte�rated di�ital entertainment and Internet services nationwide. This new alliance builds on the Company's "AOL Anywhere" strate�y as well as providing another means of higher speed access to its subscribers. The Companies will launch an extensive cross-marketina initiative to packa�e and extend the reach of both AOL TV and DirecTV. Under the Page 49 aoreement,'` Company made a 51.� billion strategic investment in � General Morors preference srock, which carries a 6-1/4% coupon rate and has a mandatory conversion into General Motors Class H common s[ock (GMH) in thrze years. ln Novemb�r 1998, the Company announced a strategic alliance �vith St�n Microsystems, Inc. ("Sun") to jointly develop a comprehensive suite of easy-to-deploy, end-to-end solutions to help companies and Intemet service providers rapidly enter the electronic commerce market and scale their electronic commerce operations. Sun will become a lead systems and service provider to the Company and the Company is comrnitted to purchase systems and szrvices worth approximateiy �400 million at list price from Sun through 2002 for its electronic commerce partners. and its oti��n use. The Company will receive more than S3�0 million in licensing, marketin� and adverising fees from Sua, plus si�nificent minimum revenue commitments of S97� million, over the next three years. Note 9. Segment Information Effective June 30, 1999, the Company adopted SFAS No. 131, "Disclosures about Se�ments of an Enterprise and Related Information." Certain information is disclosed, per SFAS No. 131, based on the way management or�anizes financial information for makin� operatin� decisions and assessin� performance. The Company currently has nvo major lines of businesses or�anized into four product �roups ��ho all share the same infrastructure. The Interactive Online Serviczs business is comprised of the Interactive Services �roup, the Interactive Proper[ies �roup and the AOL International group. The Interactive Services �roup operates the Company's interactive products: the AOL and CompuServe services and their related brand and product extensions; Netscape Netcenter; and the I�Tetscape Communicator client software, including the Netscape Navigator browser. The new product group has responsibiliry for broadband development and AOL devices like AOL TV, and is char�ed with rapidly deliverin� high-quality, �vorld-class products, features and funetionality across all branded services and propzrties. The Interactive Properties Group oversees ICQ, Di�ital City, MovieFone, Direct Marketin� Services (DMS), Spinner and Nullsofr , developer of the �iinamp and SHOUTcast brands. This �roup is responsible for buildin� new revenue streams b�� seekin� out opporcunities to build or acquire branded properties that operate across multiple services or platforms. The AOL International Group oversees the AOL and CompuServe services outside of the U.S. The AOL International Group operates the AOL and CompuServe brands in Europe with its joint venture partner Bertelsmann AG; AOL Canada, a wholly-o�vned subsidiar}� of America Online, Inc.; AOL Japan, with its joint venture parmers Mitsui and Nikkei; and AOL in Australia with Bertelsmann. America Online plans to launch services in Hon� Kon� �vith China Internet Corporation and in Latin America with the Cisneros Group. The Enterprise Solutions business is comprised of the Netscape Enterprise Group. This se�ment focuses on providin� businesses a ran�e of sofnvare products, technical support, consultin� and trainin� services. These products and services historically have enabled businesses and users to share information, mana�e nenvorks and facilitate electronic commerce. In November 1998, Americz Online entered into a strate�ic alliance with Sun Microsystems, Inc., a leader in nenvork computing products and services, to accelerate the gro�vth of electronic commerce. The strategic alliance provides that, over a three year period, the Company �vill develop and market, together with Sun, client software and nerivork application and server sofnvare for electronic commerce, extended communities and connectiviry, including software based in part on the Netscape code base, on Sun code and technology and on certain America Online services features, to business enterprises. In combination with dedicated resources from Sun, the Netscape Enterprise Group delivers easy-to-deploy, end-to-end solutions to help business partners and other companies put their businesses online. While there are no intersegment revenues between the nvo reportable se�ments, shared support service functions such as human resources, facilities mana�ement and other infrastructure support groups are alloeated based on usa�e or headcount, where practical, to the rivo operatin� segments. Char�es that cannot be allocated are reported as aeneral & administrative costs and are not allocated to the segments. Special charges determined to be si�nificant are reported separately in the Consolidated Statement of Operations and are not assi�ned or allocated to the se�ments. All other accountin� policies, as described previously in Note 2 "Summary of Si�nificant Accountin� Policies," are applied consistently to the segments, where applicabie. Page 50 A summary of the se�ment financial info;mation is as foltows: . Years end_d Jcne 30, � ------------------------------- •. i999 1998 1997 ------------ ------------ ------------ • (A:�ounts in millions) P.evenues : InteraC[ive Ozline Se:�:ices ................. Enter�rise Solu:io:�s ........................ Total revenues ........................ Incone (loss) fro- o:::a_i�r.s: InGerac[ive Ozline Sc=•::_:•s (1).(2)......... Enterorise Solutio^s. (=1........._..._..... General & Adninisc-a�:•:c .................:.. Other (3) ................................... Tota2 ir.coRe (io��i ::�- o�ezations..... $4,321 $2,726 51,786 456 365 411 $4,777 $3,091 $2,197 $ 955 S 412 $ (25�) 6 (18) 98 (408) (328) (220) (SS) (186) (106) ------------ ------------ ------------ $ 458 $ (120) $ (485) 1. Loss from o?e:�::c::� :�: :he year ended June 1997 includes $385 million write-off of deferred subscribez acquisition co�:_. 2. In fiscal 1999. �.._�:�::�e Solutions and Intezactive Oaline Services inc2ude $S million and $60 million, respectively, o: c��:il ar.d other intangible assets amoztization. 3. Other cozsis:s c`. .._: �?_cizl items: mezger, restructuzing, contract tezmination, acquired in-process research a:�d de•:e:o=-e:�: a-s3 settlenent charges. The Comp�,� d�:� no; have any material revenues and/or assets outside the United States and no sin�le customer accounts for morz tna^ 10° o o; �reater of total revenues. Note 10. Property and Equipmcnt Property and equiprncnt consist of the followin�: June 30, (in r..:=1:o^s) 1999 1993 Land......................•......._._........... $ 31 S 24 Sliid:r.gs, ecuip-�ent and related inprovements... 141 96 Lease�old a^d network improvements .............. I89 149 Fuzniture a�3 fixtures .......................... 73 S2 CompLte: e?�ipment and internal softcraze........ 494 342 Cons:ruc:ioz ir. pzogress ........................ 15 36 993 690 Less accu-llated depreciation aad amortization.. 336 186 Less zestzucturing-related adjustments..._....._ - 1 Net prop°zty ar.d equioment ...................... $657 $503 The Company's depreciation and amortization expense for the years ended June 30, 1999, 1998 and 1997 totaled $159 million, �I 10 million and S46 million, respectively. Page 51 Note 11. Commitments and Continaencies The Co�pany leases facilities and equipment p:imarily under several lon�-term operating leases, certain of which have renewal options. Future minimum payments und�r non-cancelable oper2ting lezses with initial terms of one year or more consist of the followin�: (in millions) Year endizg Jur.e 30, -------------------- ----- 2000 ................ $262 200I ................ 186 2002 ................ 129 2003 ................ 76 2004 ................ 33 Thereafter....._.... 123 $609 The Company's rental expense under operatin� leases in the years ended June 30, 1999, 1998 and 1997 totaled approximately $294 million, �261 million and �154 million, respectively. The Company has guaranteed monthly usa�e levels of data and voice communications �vith some of its network providers and commitments related to the construction of additional office buildings. The remaining commitments are �1,270 million, $1,216 million, $1,212 million and �156 million for the years ending June 30, 2000, 2001, 2002 and 2003, respectively. The related expense for the years ended June 30, ]999, 1998 and 1997, was �1,397 million, S958 million and $40� million, respectively. , As of June 30, 1999, the Company has �uaranteed approximately $17 rnillion in indebtedness of one of its joint ventures. The Company has not had to make any payments related to this euarantee during the year ended June 30, 1999. The Company is a parry to varions liti�ation matters, investi�ations and proceedin�s, including a shareholder derivative suit filed in Delaware chancery cour[ a�ainst certain current and former directors of the Company alle�in� violations of federal securities laws. The Company has settled the shareholder derivative suit and obtained the approval of the Delaware chancery court on terms that will not have a material adverse effect on the financial condition or results of operations of the Company. The Department of Labor ("DOL") is investi�atin� the app]icability of the Fair Labor Standards Act ("FLSA") .to the Company's Community Leader program. The Company believes the Communiry Leader program reflects industry practices, that the Community Leaders are volunteers, not employees, and that the Company's actions comply with the law. The Company is cooperating with the DOL, but is unable to predict the outcome of the DOL's investi�ation. Former volunteers have sued the Company on behalf of an alleged class consistin� of current and former volunteers, alle�in� violations of the FLSA and comparable state statutes. The Company believes the claims have no merit and intends to defend them vigorously. The Company cannot predict the outcome of the claims or whether other former or current volunteers will file additional actions. The cosu and other effects of pendin� or future litigation, govemmental investigations, legal and administrative cases and proceedin�s (whether civil or criminal), settlements, judgments and investi�ations, claims and chan�es in those matters (includina those matters described above) and developments or assertions by or a�ainst the Company relating to intellectual property riahts and intellectual properry licenses, could have a material adverse effect on the Company's business, financial condition and operating results. Management believes, however, that :he ultimate outcome of all pendin� liti�ation should not have a material adverse effect on the Company's financial position and results of operations. Note 12. Notes Payable During June 1999, the Company borrowed approximately �65 million in the form of two mort�a;es on its office buildin�s and land located in Dulles, Virginia. The notes are collateralized by the buildin�s and land and carry interest rates of 7.7% and 6.75%. The notes amortize over 25 years and are payable in full at the end of 10 years. As of June 30, 1999, the principal amount outstandina on these mortgages is �65 million. Page 52 During September 1997, the Company borrowed approx;mately �29 million in a refinancin� o; one of its office buildin�s. The note is collateralized by the Company's office building and carries interest at a fixed rate of 7.46%. The note amortizes on a straight-line basis over a term of 2� years and if not paid in fuli at the end of 10 years, the interest rate, from that point fonr•ard, is subject to adj�s[ment. As of June 30, I999 and 1998, the principal amount outstandin� oa this note was S28 million. On November 17, 1997, the Company sold S3�0 million of 4% Convertible Subordinated i�Totes due November 1�, 2002 (the "I�Totes"). The IvTotes are convertible into the Company's common stock at a conversion rate o` 76.637�? shares of con�mon stock for each �1,000 principal amount of the Notes (equivalent to a conversion price of �13.O�S�4 per share), subject to adjustment in certain events and at the holders option. Interest on the Notes is payable semiannually on May IS and November 1� of each year, commencing on May 15, 1998. The Notes may be redeemed at the option of the Company on or after November 14, 2000, in whole or in part, at the redemption prices set forth in the Notes. During fscal 1999, approximately 6.S million shares of common stock were issued related to conversions. At June 30, 1999, the fair value of the I�'otes exceeded the ca ,ryin� value by nearly �2 billion as estimated by tisin� quoted market prices. As of June 30, 1999 and 1998, the principal amount, net of unamortized discount, was 52�6 million and �3�� million, respectively. Notes payable at June 30, 1997, totaled ��2 million and mainly consisted of a rivo-year senior secured revolvin� credit facility ("Credit Facility"). The Comp2ny had the Credit Facility available to support its continuing growth and nenvork expansion. The interest rate on the Credit Faciliry was 100 basis poinu above the London Interbank Offered Rate and interest was paid periodically, but at least quarterly. The Credit Facility was subject to certain financial covenants and is payable in full at the end of the two year term, on luly 1, 1999. As of June 30, 1999 and 1998, there were no outs[andin� amounts on the Credit Facility and the Credit Faciliry was terminated June 30, 1999. Note 13. Other Income, Net The following table summarizes the components of other income: (in millions) Interest income ................................ Interest expense...........•-••• ............... Allocation of losses to minority s:�areholders.. Equity investment losses ....................... Gain (loss) on investments ..................... Other income Sexoense) ......................... Note 14. Income Taxes The (provision) benefit for income taxes is comprised of: Year ended June 30, ----------------- 1999 1998 1597 ----- ----- ----- $102 $37 $16 (20) (15) (2) - 6 15 (4) (10) (10) S56 17 (9) 2 (5) - ----- ----- ----- $638 S30 $10 ----- ----- ----- ----- ----- ----- Year Ended June 30, -------------------- (in millions) 1999 1998 1997 ------ ------ ------ Curzent - primazily foreign ............................................... S(2) 5(2) $(2) Defezred - primarily US federal and state ................................. (SB) 18 (8) Deferred tax charge attributable :o the Company's stock option plans.._... (28S) - - Provision foz income taxes......... $(334) $ 16 $(10) ...••••••••••-••••••• .................. Page 53 The provision for income taxes differs from the amount corr�puted by applyin� the statutory fed�ral income tax rate to income before provision for income taxes. The sources and tax effects of the differences are as follo�vs: Yezr Ended Ju:�e 3 C, ' ------------------ (in millions) 1999 1996 1997 ' ----- ------- ---- Inco,r,e tax (provision) benefit at the fedezal statutory raGe of 35°a_. $(384) $ 31 $167 State income (tax) benefit, net of federal ber.efit ............:...... (23) (6) 15 Nondeductible charge for purchased research a.^.d deve2oprent.......... - (28) (3) Nondeductible chazge for nerger related e�oenses .................... (21) - - Valuation allowance cnanges affecting the p=ovisioa for income taxes. 113 32 (181) Other................................••••••••-••••••.........••••.... (19) (131 (7) ----- ------- ---- $ (334) $ 16 $ (10) ----- ------- ---- ----- ------- ---- As of June 30, 1999, the Company has net operatin� Ioss carryfonvards of approximately �7 billion for tax purposes �vhich �vill be available to offset future taxable income. If not used, these carryforwards will expire benveen 2001 and 2019. To the extent that net operatin� ]oss carryfonvards, when realized, relate to stock option deductions, the resultin� benefits will be credited to stocl;holders' equiry. The Company's income tax provision was computed based on the federa] statutory rate and the average state statutory rates, net of the related federal benefit. Deferred income taxes reflect the net tax effects of temporary differences between the carryin� amounts of assets and liabilities for financial reportin� purposes and the amounts used for income tax purposes. Si�nificant components of the Company's deferred tax assets and liabilities are as foilo�vs: (in millions) Short term: Snort term defezzed tax assets: Defezred revenue............•••••-•••-.......... Accrued expenses and other ...................... Res[ructure reserve ............................. valuation allowance ............................. Total............••••••••••....•--• ............. Long tern: Long tern deferred tax liabilities: Capitalized softwaze costs ...................... Unrealized gain on available-for-sale securities Unremitted earnings of foreign subsidiaries .... Total..-••--.._...-••• .......................... Long term deferred tax assets: Net operating loss carryforwards ............... Deferred network sezvices czedit ............... Othez...........................••••••••.....•- Valuation allowance ............................ Total.......................................•••- Net long term deferred asset (liability).._..._ June 30, -------------- 1999 1996 $ 21 $ 30 34 19 - 32 (52) (38) $ 3 $43 5 (56) $ (33) (103) (89) (6) - (155) (122) 2,670 412 101 131 95 B (2,714) (426) 152 125 S (3) $ 3 The valuation allowance for deferred tax assets increased by 52,302 million in fiscal 1999. The increase in this allowance was primarily due to the benefit generated from the current year exercise of stock options and warrants of $2,609 million and certain deferred tax assets associated with acquisitions of 59� million which will result in future tax deductions. The benefit from the fiscal 1999 exercise of options and warrants will be recorded to stocl:holders' equity as it is realized. This increase was Page 54 partially offset by (1) the utilization of �284 million•of benefits �enerated from prior years' exercis�s of stock options to reduce fiscal 1999 income taxes payable and (2) the utilization of net operatin� losses relatin� to book taxable income of approximately �171 million resulting in valuation allowance chan�es affectin� the provision for income taxes. The Company has net operatin� loss carryfonvards for tax purposes ("NOLs") and other deferred ta� benefits that are available to offset future taxable income. On1y a portion of the NOLs are attributable to operatin� activities. The remainder of the Iv'OLs are attributable to tax deductions related to che exercise of stock options. Prior to the third quarter of fiscal 1998, the Company followed tfie praciice of computing its income tax expense usin� the assumption that current year stock option deductions were used first to offset its financial statement income. NOLs could then offset any excess of financial statement income over current year stock option deductions. Because stock option deductions are not reco�nized as an expense for financial reportin� purposes, the tax benefit of stock op:ion deductions must be credited to additional paid-in capital �vith an offsettin� income tax expense recorded in the income statement. The Company changed its accounting for income taxes to reco�nize the tax benefits from current and prior years' stocl: option deductions after utilization of NOLs from operations (i.e_, I�OLs determined without deductions for eae;cised stock options) to reduce income tax expense. Because stock option deductions would have been utilized fo* financial accountin� purposes in prior years under both accountin� methods due to the absence of NOLs from operations, this accountin; change had no effect on 1997 and prior years' tax provisions or additionai paid-in capital. The effect of this chan�e was to increase net income and diluted earnings per share for the year ended June 30, 1998 by $73 million and �0.08, respectively. The Company's deferred tax asset related to operations and exercised stock options amounced to: June 30, (in millions) 1999 1998 Operations..... S 141 S 252 Stoc;c options.. $2,626 5 383 When realization of the deferred tax asset is more likely than not to occur, the benefit related to the deductible temporary differences attributable to operations will be reco�nized as a reduction of income tax expense. The benefit related to the deductible temporary differences attributable to stock option deductions will be credited to additional paid-in capital when realized. Note 15. Capital Accounts Common Stock At June 30, 1999 and 1998, the Company's S.O1 par value common stock authorized was 1,800,000,000 shares with 1,100,893,933 and 973,150,052 shares issued and outstandin„ respectively. At June 30, 1999, 237,009,873 shares were reserved for the exercise of issued and unissued common stock options, and convertible debt, and 10,074,160 shares were reserved for issuance in connection with the Company's Employee Stock Purchase Plans. Durin� July 1998, the Company completed a public offerin� of common stock. The Company sold approximately 21.6 shares of common stock and raised a total of �550 million in new equity. The Company used the proceeds for aeneral operatin� purposes. In addition, the Company sold approximately 3.8 million and 2_3 million shares in fiscal 1998 and 1999, respectivel.y, and had net proceeds of approximately $S million and 519 million in the same time periods. Preferred Stock In February 1992, the Company's stocl:holders approved an amendment and restatement of the certificate of incorporation which authorized the future issuance of 5,000,000 shares of preferred stock, S.O1 par value, with ri�hts and preferences to be determined by the Board of Directors. Durin� May 1996, the Company sold 1,000 shares of Series B convertible preferred stock ("the Preferred Stock") for approximately $28 million. The Preferred Stock had an a��re�ate liquidation preference of approximately $28 million an�l accrued dividends at a rate of 4% per annum. Accrued dividends could be paid in the form of additional shares of Preferred Stock. During May 1998, the Preferred Stock, plus accrued but unpaid dividends, automatically converted into 1,568,000 shares of common stock based on the fair market value of common stock at the time of conversion. Warrant In connection with an a�reement with one of the Company's communications providers, the Company had an outstandin� warrant, that was exercised durin� March 1999. The warrant, subject to certain performance standards specified in Paae 55 the a�reem _.,., allowed tne Company's communication provider to purchase 2S,SOO,GuO shares of common stock at a price of $4.4922 per share. Shareholder Riahts Plan The Company adopted a ne�v shareholder ri�hts plan on May 12, 1998 (the "New Plan"). The New Plan was implemented by declarin� a dividend, discributable to stockholders of record on June 1, 1995, of one preferred share purchase ri�ht (a "Ri�ht") for each outstandin� share of common stock. All ri�hts �ranted under tne Company's former shareholder ri�hts �plan adopted in fiscal 1993 �vere redeerled in conj�.�nction �vith the i�plemen?ation of the New Plan and the former plan was terminated. Each Ri�ht under the New Plan �vill initia]ly entitle re�istered holders of the common stock to purchase one one-thotisandth of a share of the Company's rew Series A-1 Junio: Participatin� Preferred Stock ("Series A-1 Preferred Stock") at a purchase price of �900 per one one-thousandch of a share of Series A-1 Preferred Stock, subject to adjustment. The Rights �vill be exercisable only if a person or �roup (i) acq�iires 1�% or more of the common stock or (ii) announces a tender offer that would result in that person or �roup acquirin� 1�% or more of the common stock. Once exercisable, and in some circumstances if certain addi[ional conditions are met, the Ne«� Plan allows stockholders (other than the acquirer) to purchase common stock or securities of the acquirer having a then current market value of nvo times the exercise price of the Ri�ht. The Ri�hts are redeemable for �.00I per Right (subject to adjustment) at the option of the Board of Directors. Until a Ri�ht is exercised, the holder of the Right, as such, has no ri�hts as a stockholder of the Company. The Ri�hts will expire on May 12, 2008 unless redeemed by the Company prior to that date. Stock Splits In November 1994, April 1995, November ] 995, March 1998, November 1998 and February 1999, the Company effecied nvo-for-one splits of the outstandin� shares of common stock. Accordingly, all data shown in the accompanyin� consolidated financial statements and notes has been retroactively adjusted to reflect the stock splits. lvote 16. Stock Plans Options to purchase the Company's common stock under various stocl: option plans have been �ranted to employees, directors and consultants of the Company at fair market value at the date of grant. Generalfy, the options become exercisable over periods ran�in� from one to four years and expire ten years from the date of grant. In certain of these plans, the Company has repurchase rights upon the individtial cessation of employment. Generally, these rights lapse over a 48-month period. In fiscal years 1998 and 1997, the Board of Directors authorized approximately 11 million options to be repriced. The vesting schedules were not materially chan�ed and no employees o�r•nin� 3% or more of the Company's common stock nor any senior executives participated in the repricin�. The effect of applyin� SFAS No. 123 on 1999, 1998 and 1997 pro forma net loss as stated below is not necessarily representative of the effects on reported net income (loss) for fut�ire years due to, amon; other things, the vestin� period of thz stock options and the fair value of additional stock optioas in future years. Had compensation cost for the Company's stock option plans been determined based upon the fair value at the arant date for a�vards under the plans consistent with the methodology prescribed under SFAS No. 123, the Company's net income (loss) in 1999, 1998 and 1997 would have been approximately $504 million, �(132) million and $(625) million, or �0.39 per share, �(0.14) per share and $(0.75) per share, respectively, on a diluted basis. The fair value of the options �ranted during 1999, 1995 and 1997 are estimated at $22_93 per share, $5.28 per share and � 1.13 per share, respectively, on the date of �rant usin� the Black-Scholes option-pricing model with the following assumptions: no dividend yield, volatiliry of 65%, a risk-free interest rate of 5.40% for 1999, 5.51% for 1998 and 5.69% for 1997, and an expected life of 0_45 years from date of vestin�. A summary of stock option activity is as follows: Page 56 Number tieignted- of avezage exercise shares pzice � ------------- ---------------- Balance at Jur.e 30, 199'.. 260,774,430 S 1.63 Graated..� ................. 52.198,506 $ 3.90 Exercised ................. (55.724.657) S 1.26 Forfeited ................. (25,013,143) $ 2.93 ------------- ---------------- Salance at June 30, 1997.. 232,234,836 S 2•'-S Granted ................... 81,370,433 $12.37 Exercised ................. (73,707,980) 5 1.51 £orfeited ................. (17,534,536) 5 4.92 ------------- ---------------- Saiznce at June 30, 1998.. 222,362,753 $ 5.68 Granted ................... 54,?65,388 550.55 Exercised ................. (61.202,205) S 3.38 Forfeited ................. (16,356,6771 519-69 ------------- ---------------- Balance at June 30, 1999.. 199,569,259 $17.75 Options outstanding Optioas exercisable --------------------------------------- ------------------------ Weighted- average Weighted- Weighted- Number remaining average Number average Range outs:anding contractual exercise exercisable as exercise of exercise price as o: 6/30/99 life (in years) price o`_ 6/30/99 pzice ------------------- ------------- --------------- --------- -------------- --------- $0.01 to S1.70..... 34,328,228 5.0 50.90 33,372,307 50.91 $1.72 to $3.39..... 40,668,741 6.6 $2.81 20',246,169 $2.57 $3.46 to $6.06..... 37,213,772 7.7 56.83 11,431,800 $6.08 $8.44 to 521.93.... 35,015,933 8.4 $15.83 6,761,363 $15.42 $21.94 to $45.49... 36,813,111 9.2 $24.74 2,187,451 $26.44 $45.69 to $90.13... 4,147,119 9.6 577.82 329,231 $74.06 $90.88 to $128.32.. 7,503,079 9.8 $112.03 11,919 $108_15 $129.07 to $16�.50. 3,879,276 9.8 $141.76 I93,115 $141.07 ------------------- ------------- --------------- --------- -------------- --------- $0.01 Go $167.50... 199,569,259 �.6 $17.75 80,523,345 $4.74 Employee Stock Purchase Plan In May 1992, the Company's Board of Duectors adopted a non-compensatory Employee Stock Purchase Plan ("the ESPP"). Under the ESPP, employees of the Company who elect to participate are granted options to purchase common stock at a 15 percent discount from the market value of such stock. The ESPP permits an enrolled employee to make contributions to purchase shares of common stock by havin� withheld from his or her salary an amount between 1 percent and 15 percent of compensation. 'The Stock and Option Subcommittee of the Compensation and Management Development Committee of the Board of Directon administer the ESPP. 'I�e total number of shares of common stock that may be issued pursuant to options aranted under the ESPP is 14,400,000. A total of approximately 6 million shares of common stock have been issued under the ESPP. In June 1995, the Company adopted a non-compensatory Employee Stock Purchase Plan ("the Netscape ESPP") under Section 423 of the Interna] Revenue Code and a total of 3,150,000 shares of common stock may be issued punuan[ to options under the Netscape ESPP. The Company's Board of Directors in 1998 amended the Netscape ESPP to increase the maximum percentage of payroll deductions which any participant may contribute from his or her eli�ible compensation to 15%; amended the Neucape ESPP from a two-year rolling offerin� period to a six-month fixed offerin� period effective with the offerin� period beginning March 1999; amended the limit to the number of shares any employee may purchase in any purchase period to a maximum of 1,800 shares; and chan�ed the offering dates for each purchase period to March 1 and Ssptember 1 of each year. Under this plan, qualified employees are entitled to purchase common stock at a 15 percent discount from the market value of such stock. Approximately 2 million shares of common stock have been issued under the Netscape ESPP. Page 57 Note 17. Er- �loyee Benefit PIan Savines Plans The Company has two savin�s plans that qualify�as a deferred salary arrangement under Section 401(k) of the Intemal Revenue Code. Under the plans, participating employees may defer a portion of their pretax eamin�s. In one plan, the Company,matches �0% of each employee's contributions up to a maximum matchin� contribution of 3% of the employee's eamings and in the otner plan, the Company's contributions are discr�tionary. The Company's contributions to plans were approximately S6 million, S� million and �3 million in tne years ended Iune 30, 1999, 199S and 1997, respectively. Note 1S. Quarterl�• Information (unaudited) Fiscal 2999(1)(3i Subscriotioz ser:ice :e•:er.•.:es ............... Advertising, cor..-^::e a-:� o:h=r revenues.... Enterprise solutio- :c�e-::es ................ Total revenues .............................. Income from o�era::�-� ...................... Net income .....................••-......_.. Net income pe: s.`.a:c-c:l�:c3 ................ Net incone per s:�:c-5�s:c ................. Net cash provide_ t;• o�e:a�ir.g activities... Earnings Before I�:e:es�, ?axes, Depzeciatioz ar.� ...-�zt.:a�:c:: (EBITDA) (4) .. Fiscal 1998(2)(3J Subscrietion servicc zevenucs........--•••-- Advertising, cor.=c:ce a�3 o:he: =evenues.... Enterprise solu:io� reve�ues ................ Total revenues .............................. Ineome (loss) fzo- o�e:a_io:�s ............... Net income (loss) ........................... Ne� income (loss) p^_: shaze-diluted..._..... NeG income (loss) per share-basic........... Net cash provide3 b� o?era�ir.g activities... Earnings Sefore Ir.:e:est, Taxes, Depreciatioa and t,.:.o_�izatio:� (ESITDA) (4) .. Qua-tez Endec --------------------------------------------- Septecwer 30, Decer,iber 31, Diarch 31, June 30, ------------- ------------ --------- -------- (Amouats in millions, exceo� oer share data) $723 $786 $869 $943 175 244 275 306 101 118 109 128 ------------- ------------ --------- -------- 999 1,148 1,253 1,377 77 123 47 211 76 . 115 411 160 $0.06 $0.09 $0.32 $0.13 5o.os So.iz $0.39 So.is $120 $178 $605 $196 153 221 251 3S3 $439 $488 $SBO $676 106 131 142 164 123 104 35 103 ------------- ------------ --------- -------- 668 723 757 943 25 (54) (83) (8) 31 (34) (78) 7 $0.03 $(0.04) $(0.08) $0.01 $0.04 $(0.04) $i0_08) $0.01 $125 $57 $130 $125 76 4Z 31 15S The special charges referred to below include charges for restructurin�s, acquired in-process research and development, mer�ers, transition costs, settlements, w•rite-off of deferred subscriber acquisition costs and contract termin�ations. (1) Net income in the fiscal year ended June 30, 1999 includes special char�es of �2 million in the quarter ended December 31, 1998, a78 million and S25 million in the quarter ended March 31, 1999 and $15 million in the quarter ended June 30, 1999: Net income in the quarter ended March 31, 1999 also includes a�ain on the sale of Excite, Inc. investcnents of approximately �567 million. (2) Net los's in the fiscal year ended June 30, 1998 includes net charges of $42 million in the quarter ended December 31, 1997, $58 million in the quarter ended March 31, 1998 and �88 milli�n in the quarter ended June 30, 1998. (3) The sum of per share earnin�s (loss) does not equal earnin�s (loss) per share for the year due to equivalent share calculations which are impacted by the Company's losses, fluctuations in the Company's common stock market prices and the timin� (weightin�) of shares issued. (4) EBITDA is defined as net income plus: (1) provision/(benefit) for income taxes, (2) interest expense, (3) depreciation and amortization and (4) special charges. The Company considers EBITDA an important indicator of the operational strength and performance of its business including the abiliry to provide cash flows to service debt and fund capitai expenditures. EBITDA, however, should not be considered an alternative to operating or net income as an indicator of the performance of the Company, or as an alternative to cash flows from operatin� activities as a measure of liquidity, in each case determined in accordance with generally accepted accountin� principles ("GAAP"). Page 58 REPORT OF MANAGENiEivT The managzment of Anerica Online, inc, is responsible for the integriry and objectiviry of the financiai and operatin� ��formatioa contained zn this Anaua'i'Report an Form i0-K, includin� the consolidated financial statements covered by the :epor of In�ependent Auditon. These st2t�ments wes�e prepa:ed in conformiry with generzlly accepted accounting principies and include amouncs that are b2sed on the best estimates and jud�menu of mana�ement, which it be}ieves, are reasonable under the circu�stances_ ' �'he Company maintains a system of internal accounting policies, procedures and controls designed to provide mana�ement with reasonabie assurance that asseEs are safeguarded against loss from unauthorized use or dispositiol, and ti�ac transactions are executed in acco�ance with manaaemen�'s authorization and recorded properly. The systen was enhanced witn the fiscai 1999 fou�th q►tarter iaitiation of a#'ormaI Standards of Business Canduct :osterin� z strong ethicai climate. Tne Co�paay also ma'sntains ar� internal auditing functiort, which evaluates and formaliy repo; ts on ihe adequacy and effectiveness of intemaI accountiag and operationat controls and procedur�s. Ernst & Young LLP audiu the Compaay's financial statemer:rs in accordanee with �enerally accepted auditing siandards anci provides an objective, independent revie�v of the Company's intemal control and the fairness of its reported �nancial condition aad resuits of opesations. in addition, the Audir Cornmittee of the Board of Airectors, consistir.� solely of outsie�e directors, meets per;odicat�y with mana�emenc, the independent auditors and intern2i auditors to review iniemai acco;�nii,n� controls, audit results and accotinting principies and practices, aad antinally recomrnends to the Board of Directors ttie selection of independent auditors. STEP�-iEN M: CASE Chainnan of the Boarci and Chief Execative Officer J'. MICHAEL ICELLY Seniar Vice President and Chief Financial Offcer Page 59 Exhibit 10.1 America Online, Inc. Employee Stock Purchase Plan (Amended and Restated Effective as of July 28, 1999) 43243.8 1998 Annual Report � � �: ' ' �'/ . �, y� 1't � � .C� � � , y( � �'. • .i � WHAT DRIVES OUR 'rO,Iw � • ■ � � ■�■ ��■ ��E�� [ ■�'�H, �� ■ ■' T'� . S ■�m :, .. e � �' 2. O ............................................................................................. ............................................... Financiai Highlights Combined Revenues (millions) Combined EBITA�b� (millions) .............................. ..� .� 1996 (a) 1997 1998 prp Forma�al 1997 Pro Forma I 1998 Combined Revenues�d� $26,838 Million I Cable Netwc-'�� 'A0` Publishing ' Entertainme� ' Cable 19Mo Combined Capitalization (millions, as of December 31) $104,270 � ........................................ :. ........ 564,294 $46,080 ' ' ' � � � 1998 1996 1997 1998 S:; Net Debt & Other�`� � Market Equity Cat� _ satron 1998 Combined EBITA�d� $4,462 Million �—Cable Networks 26% ........................... ,, .......................... , Publishing 13% rEntertainment 2496 Cable�b� 3796 � These financial highlights of Time Warner and the Ente�tainment Group, substantially � all TWE, have been presented on a combined basis. Such financial highlights should � be read in conjunction wilh Managemenfs Diswssion and Analysis and Time Wamer's Consolidated Financial Slatemenls appearing elsewhere herein. In such financial statements, Time Warner does not consolidate the Entertainment Group. (a) Pro forma results for 1996 give effect to the acquisition of Turner Broadcasting System, Inc., as if it occurred at the beginning of the period. (b) Includes net pretaz gains of approximalely $108 million in 1998 and $212 million in 1997 related to the sale or exchange of certain cable television systems. (c) Includes net debt, Series M preferred stock, preferred securities of subsidiaries and borrowings against future stock oplion proceeds. (d) Percentages calculated before intercompany eliminations. Cautlon Concermn9 Forward-Look�ng Stalements—This Annua 4_port includes certain'forward-looking statements' within the meaning ot the ?� •ate Securities L�tigalion Refo�m Act of 1995. These statements are based on —�nagemenYs wrrent expectat�ons and are natureily subjed to uncertainty ar: :�anges in circumstances. Attual resuNs may vary materiallyfrom the expec -;ions containec herein due to changes �n economlc, busmess, competitive, techr�,; pgical and/or regulatory factors. More detailed information about those factor: __ set forth in t�_ financial stalements on page 33. Tme Wamer is under no obl�cz- on to (and e=re=: . disclaims any such obllgaLon to) uptlate or alter its forward-loo� ^� statements .:-r'-e- as a result o1 new inlormat�on, future events or otherwise. ■$�a��. e ■■ ..........e ............. .�� ■ � �=: ■ V � �..., -. � �.m. . . . . . . . . �� w��:��, s ■�. a■ �7 ■LZ � �� B @ � � � ■ ■�■ ■ ■ ■ ::• �- ■ B�pY� ■� � '~'■ g6d ++ � G! ■ ■ � a �■ ■ �� ■�o■ �° ■ �° R c� g '�.. � �.... . 6 0 B Q1-96 Q2-96 Q3-96 Q4-96 Q1-97 Q2-97 i• — _. �■ ■• . . . . . ... .. . . . . .. . . . . . . . . . . . . . . . . . . . . . . . . . .. . . . . .. .. . . . . . . . . . .. . . . . . .. . . . . . . . . . . . . . . . . . . . . . . . . . . . . .. . . .. . . . . .. . . . . . .. . . . . . .. . . . . . . . . . ,� !. . .sso a' Time Warner � 1998 Annual Report _ � — ■■ — ■' — ■ ■ t t: ■�. — ■■ !■ ■ ,,. � ■`- — .............................................................�...............550 ■ ■� _ � ■ � — ■ �■ ■ � — ' ■■ ■ ��■ ■ � �� • — e�■ ,, � ��■ �n — .: '`�� ■ ■ ■ _ � ■ ■ ■e ' ■ �' ■ ■ � �� 0 E � e — ■ �' ■ ......................... ................540 .......................................................................�..r �......... �......... ■ ■■ ■ ■ ■��■ e — � ■ g� rt��■ — ■��■ ■ ■�� ■ ■ � g ■ G — !�C■ ■ _ d .� n ■ � -- ��■ ■� . -- i � ,. � — .. � ..A. .!.. " .............................. ........................�-- -- � ...................................................................... ' ■ .::....■�:r:�.; I ■••mR�•�i� — ■�� ■ ■ ■ ■'� � ■�■ • ( � � ■ 8 ■ ---- I � � e — i ■ �■ � ...AND HOW IT WILL BE s u s al ne � OVER THE LAST THREE YEARS, A PERIOD IN WHICH THE OVERALL MARKET ROSE SHARPLY, —. TIME WARNER ACHIEVED AN INCREASE NEARLY TWICE THAT OF THE S�P 500. OUR ABILITY TO DELIVER ...................................................................................................................520 ---- SUSTAINABLE GROWTH AND OFFER SUPERIOR RETURNS TO OUR SHAREHOLDERS IS BUILT ON THE COMPETITIVE LEADERSHIP OF OUR WORLD-CLASS INFORMATION AND ENTERTAINMENT BRANDS -- AND ON A FOCUSED COMMITMENT TO OUR IONG-RANGE FINANCIAL PLAN. -- Q3-97 Q4-97 Q1-98 Q2-98 Q3-98 Q4-98 Gerald M. Levin Chairman and Chief Executive Officer "Our c ommitm n ' e t wlll alwa s be Y to enerate sustainable r t" g g ow h. 2 TIM� WARNER INC 1998 ANNl1AL RFPORT Dear Shareholders: As the graph on the inside cover makes clear, our investments in building Time Warner's integrated array of brands are delivering a dynamic return. In 1998 our share price doubled, a gain close to four times the S&P's. Obv�ously, no company can replicate a perfor- mance like that every year, and in a down market even the best of the blue chips can get battered. Yet despite inevitable economic dips and market volatility, our commitment will always be to generate sustainable growth and accelerate our return on invested capital. Measured by the most reliable benchmark of all— operating performance-1998 was the best year in Time Warner's history. Results for our businesses were outstanding. Cable Networks, Publishing, Filmed Entertainment and Cable Systems set new operating records. Music had the turnaround year we expected and is back on its growth trajectory. Time Warner's 71ME W�RNER INC �998 ANNUAL RLPORT 3 In 1998 we reached a key financial goal that we set for ourselves: solid investment-grade status. The momentum of our businesses is built, in part, on our success in turning trends into engines of growth. combined operating income before amortization (EBITA) increased a solid 14 percent on a pro forma basis. Along with posting strong growth, we kept a lid on both fixed capital and production spending. We also extended our cost-reduction program to more than $600 million in annual savings, which we expect to rise to $800 million by the end of 1999, The resulting increase in free cash flow enabled us to strengthen our balance sheet and thus reach a key financial goal we set for ourselves in 1998: solid invest- ment-grade status. This significant milestone, which we are determined to preserve, is the necessary preface to the next phase of our financial plan. We will use our growing free cash flow to buy back stock and make further strategic investments that leverage our assets into new opportunities for growth. s ; . . +�iilC."� 1i7�� ii�taie�,ih�;� t;ru�� th In the pages following this Letter, you'll see highlighted three trends—demographics, globalization and technology—that increasingly drive our performance. While their impetus to future growth can be stunning, it's important to remember tha! trends don't guarantee results. Their impact will be realized only by those 4 TIM� N/PRNER IN� ioug q��..�U.1L RE�ORT enterPrises with the talent and imagination necessary to stay ahead of the curve, anticipating change instead of inerely reacting to it. Our ability to understand our audiences, locally as well as globally, and to reach them through virtually every medium with brands that set the quality standards in news, information and entertainment, means we are able to utilize these trends to propel Time Warner's competitive leadership. The momentum of our businesses is built �n part on Time Warner's mastery of what it takes to originate brands that turn trends into engines of growth. In the case of our vice chairman, Ted Turner, his gift for spotting trends and then get- ting there first with distinc#ive businesses has helped revolutionize global media. More than twenty-five years ago a handful of pioneers— Ted prominent among them—perceived that cable offered a way of ineeting a generational desire for more and better choices in program- ming. Out of that perception has come Time Warner's galaxy of cable networks, including CNN, TBS Superstation, TNT, Cartoon Network, Turner Classic Movies, HBO and Cinemax. The shift of viewers from broadcast to cable that began two decades ago has passed the point of no return. With the exception of the impressive feat by Time Warner's broadcast net- work, The WB, in creating its own demographic niche, every broadcast network experienced a decline in viewership in 1998. Time Warner's Cable Networks are the biggest beneficiary of this historic change. Their success in building new audiences will continue to depend on the diversity and quality of their programming. Time Warner's libraries of 5,700 films—including a growing number of hits from Warner Bros. and New Line—the 13,500 animation titles, including those from Looney Tunes, Hanna-Barbera and DC Comics, and 32,000 television titles are an unmatched source of such content. Our lineup of leading television b�ands in news and entertainment currently garners a quarter of the cable industry's advertising share. Overall, the steady and continuing rise in cable viewers is beginning to be reflected in a redistri- bution of advertising dollars, but there is still a considerable gap. Basic cable has almost half of television's audience yet less than 30 per- cent of its advertising revenues. As advertisers increasingly turn to cable to reach the audi- ences they seek, the disparity will narrow. We fully expect to win a substantial piece of this multi-billion-dollar advertising shift. In pay television, the primary position of Home Box Office is built on its programming and marketing prowess and use of new technology. HBO remade the television universe almost twenty-five years ago with satellite distribution of cable programming. Now, HBO and Cinemax are driving subscriber growth through multiplex- ing, using expanded channel capacity to offer 10 channels targeted to selected demographic segments of their audiences, and through HBO's distinctive brand of original programming. Widely acclaimed hit series like The Sopranos, as well as the upcoming miniseries Band of Brothers—executive produced by Tom Hanks and Steven Spielberg—ieave no doubt about HBO's leadership. Time Inc. is in a publishing ciass by itself. What sets Time Inc: apart isn't merely its size- it's bigger than the next two largest magazine publishe�s combined—but its entrepreneurial inventiveness. In addition to weeklies like People, Time and Sports lllustrated, which the Publishers Information Bureau ranked as the industry's 1998 top revenue leaders, ours is the only publishing company to have launched nine major magazines in the past decade. These include Entertainment Weekly and In Style, as well as Teen People and People en Espanol, which immediately clicked with the demographic groups to which they are directed. Time Inc:s extraordinary ability to marry journalistic excellence with an exquisite sense of readers' desires remains the basis of sustainable double-digit growth. Multiplexing and expanded channel capacity are allowing HBO to target selected demographic segments. Time Inc:s entrepre- neurial inventiveness has produced nine major new magazines in the past decade. rIME W;.RNF.P',1C ta,tn.lv^.'�:�I �:i .. : �J An important ingredient in producing predictable growth is Warner Bros.' decade-long reign as the leading supplier of primetime television programming. The use of the Internet by our music labels promises to be as far- reaching a marketing tool as radio and music television. Warner Bros: record year was a testament to its status as an integrated global entertain- ment company. Notable worldwide hits like Letha/ Weapon 4 and You've Gof Mail, however, couldn't bring overall box-office results up to that of past years. On the cost side, Warner Bros. is reducing its financial exposure by increasing the number of joint-ventured films. A key ingredient in producing predictable growth is Warner Bros: decade-long reign as the leading supplier of primetime television pro- gramming. Following the successful syndication of ER and Friends, The Orew Carey Show will go into the pipeline this year and should also be among the top syndicated shows. Technology, in the form of DVD, is providing another stimulus to growth. Warner Home Video's 1998 sales of DVDs accounted for more than 10 percent of its gross domestic sales. With over 1.5 million DVD players shipped by manu- facturers, putting the DVD way in front of where the CD and VCR were at this stage of their introduction, the growth from the digital resale of our film libraries is poised to take off. The star power of Warner Music Group's roster of performing artists was preeminently displayed in 1998, with hit releases from Madonna, Jewel, Alanis Morissette, Barenaked Ladies and Brandy. Combined with the overall recovery of domestic music sales, where our 6 TIME WARNER INC. 7998 ANNUAL REPORT share remained at about 20 percent, the sched- ule of 1999 releases—Eric Clapton, Enya, Paula Cole, Third Eye Blind, Luis Miguel, Faith Hill and Red Hot Chili Peppers among them— should continue the Group's improved perfor- mance. Longer term, the use of the Internet by our labels to promote and market their artists promises to be as far-reaching a marketing tool as radio and music television. Warner Music International's expanding number of local artists—currently more than 1,000—points to the opportunities we have for substantially enhancing growth outside the U.S. As the recent investments by Silicon Valley and the acquisition of TCI by AT&T have helped spotlight, the cable industry sits astride the strategic center of the digital revolution. It will play a major role in making interactivity an indispensable part of people's lives. Time Warner Cable's double-digit growth, however, is a present-day fact, not a future projection. Its record results for 1998 were due largely to the solid fundamentals of the basic business. As a result of the rebuild of our cable infrastructure, scheduled to be 85 percent complete by the end of 1999 and finished by the end of 2000, our effectively clustered systems are the industry's most technologically advanced. Richard J. Bressler R.E Tumer Geraid M. Levin Richard D. Parsons Executive Yce President Vice Chairman Chairman and President and Chief Financial Officer Chief Executive Officer "For Time Warner, there is an inseparable link between our values and the value creation we offer our shareholders." Ti+nE wARNER iNC '�98 nNkUAL RF'OR7 7 Cable's elegant embrace of the digital realm gives us full access to the revoiu- tionary possibilities of the internet–portals, high-speed delivery and e-commerce. Everything we do calls �n the imaginative, ntellectual and entre- xeneurial talents of the people who work here. The installation of coaxial/fiber-optic architec- ture makes possible far more reliable service, expanded channel capacity and added pay per view. With a cable modem, it creates a whole new business—Road Runner, ourjointly owned high-speed online service. Including our part- ners' systems, Road Runner had over 180,000 subscribers at the end of 1998 and will roll out in another ten cities in 1999. This year, the next generation of digital set- top technology—which we have been testing in our Austin, Texas, cable system—will be available in another 20 systems: By more than doubling the number of channels and offering new on-demand opportunities, these digital boxes will generate a steady source of incremental cash flow. One indication of the benefits our rebuild is delivering is our initiative with AT&T. Without additional investment by Time Warner, and on top of up-front and per-subscriber payments by AT&T, we are putting in place a joint venture that wiil allow us to share in the results of introducing real competition into the local phone business. The partnering of Time Warner with ATB�T is a notable step toward bringing the full benefits of broadband technology to America's homes and businesses. The biggest winner of all will be the consumer. 8 ii.\tE Y:ARNCR iNC '99B A�uNUAL RE?ORT Combined with Time Warner's position as the worid's premier programmer and direct marketer, Cable's elegant embrace of the digital realm gives us—as it gives no other media company—full access to the revolutionary possi- bilities of the Internet. Whether iYs high-speed delivery through our broadband cable architec- ture, or the portals and myriad Web sites our businesses have in place, or the direct-marketing infrastructure we bring to e-commerce, Time Warner is optimaliy positioned in every phase of what has already emerged as the formative com- munications paradigm of the 21 st century. UZ�L1�S 111C� Value Creation Our businesses are intimately interwoven with the human mind and heart. Everything we do calls on the imaginative, intellectual and entrepreneurial talents of the people who work here. More than any other asset, it is their role as journalists and storytellers, their integrity and artistry, their insight and innovation—their passionate commitment to whatever they do— that is the reason we enjoy a reputation as the world's most trusted source of news and information, and why audiences around the globe turn to us for the best in entertainment. The job of attracting and nurturing the women and men who are directly responsible for the day-in, day-out success of our brands, whose sense of mutual respect and teamwork underlies our future growth, Can't be done in a vacuum. We have to be clear about the values that make us who we are and define what we do. These values aren't about feeling good. They're about performing well. For Time Warner, there is an inseparable link between our values and the value creation we offer our shareholders. In 1998, we established a Values and Human Development Committee of the Board to begin the process of examining those values that are shared throughout our company and that must guide the behavior and expectations of all of us. For this initiative to have a lasting impact. as well as for the values we identify to be part of the everyday conduct of our business, people throughout the company must know that their views are both wefcomed and desired. To this end, an energetic, diverse working group has opened a cross-divisional discussion that, through electronic forums and face-to-face meetings, will be made as inclusive as possible. Henry Luce, the co-creator of Time and one of the progenitors of Time Warner, wrote that our company was an enterprise formed "in the public interest as well as the interests of shareholders" Luce believed that in the commit- ment to bring the public a degree of reliability and quality beyond anything competitors could offer, he was forging a bond that would enhance the reputation and worth of the entire company. That bond of trust is as important now as ever. Indeed. it has always reached beyond the traditional boundar�es of business to a range of educational and community projects that has become so extensive we issue a special biennial Community Responsibility Report to cataiogue all that's involved. (Due out in May, it will be available in hard copy and electroniCally at www.timewarner.com) Creating shareholder value will always be about more than keeping score or staying ahead of the competition. That was brought home to me once again at last year's annual meeting at the CNN Center in Atlanta. A shareholder expressed in very personal terms the heightened opportunities for education and enjoyment that the rise in our stock price has proyided her family. As gratifying as that was to hear, it was also a reminder of our unchanging responsibility to live by the basic values, make the material investments and take the creative risks that will enable us to generate sustainable growth far into the next millennium. I'm more confident than ever that we will meet this responsibility and be tomorrow what we are today: the world's leading media and entertainment company. Gerald M.Levin Chairman and Chief Executive Officer March 9, 1999 . !� We have to be clear about the values that make us who we are and define what we do. � Our unchanging responsibility is to live by our basic values, make the investments and take the risks that can generate sustain- able growth for years to come. TiME WaR�[R IN� I?9d :.V�'�;.; R��'Ja' 9 GG �an o r ovv. . . DRIVING THE GROWTH OF GLOBAL MEDIA IS THE SHARED AND INSATIABLE HUMAN DESIRE TO BE INFORMED AND ENTERTAINED. AS WE APPROACH THE 1.iST CENTURY, THREE POWERFUL . TRENDS ARE GENERATING EXCITING NEW OPPORTUNIT�ES TO SERVE AND INTENSIFY THIS DESIRE. DEMOCaRAPH/C SHIFTS HAVE CREATED SIGNIFICANT AUDIENCE SEGMENTS ALL OVER THE WORLD WITH UNIQUE TASTES AND INTERESTS, AND THE ECONOMIC..CLOUT TO GET WHAT THEY WANT. GLOBALIZATION IS MAKING THE WORLD BOTH SMALLER AND MORE DIVERSE, WITH THE DEMAND FOR BOTH INTERNATIONAL AND LOCAL CONTENT INTEN�SIFYING AS INCOME LEVELS RISE WORLDWIDE. TEGHNOLOCaY HAS TURNED THE DIGITAL AGE FROM PROPHECY TO REALITY, ACCELERATING CONSUMERS' ABILITIES TO GET WHAT THEY WANT WHEN THEY WANT IT. WITH ITS EXCEPTIONAL TALENT FOR BOTH TRENDSETTING AiJD TRENDSPOTTING, TIME WARNER WILL GROW BY CONTINUALLY GENERATING NEW PRODUC7S AND SERVICES TO MEET THESE CHANGING DEMANDS. Industry Trends Driving Gro�vth ,�..,: r ��` _ ��' • ; � �`'.�.�`- �` � � .�: �: �°� _ -�l,r . � � .�. ; �: ,� y:�.*� 'r-�� ,-. �� ',�-,.;�.::: �r' ~; p � ,.yz; � � , � �r.v,. . - �. . i :�s. "s `� � ��. .... ��.__ �4 �r �< . ,: :.: � . ... .,� `� s_..y<.�. ,�.��x. � �.., ti° - r � � ,:.a� ^� `:� D�'!111�`� l��l}� li I � �. THE SIGNIFICANCE OF POPULATION GROWTH GOES BEYOND THE INCREASING NUMBER OF PEOPLE IN THE WORLD. WITHIN THE MASS AUDIENCE FOR INFORMATION AND ENTERTAINMENT, THERE ARE NEW AND ECONOMICALLY IMPORTANT CONSUMER SEGMENTS DEFINED BY FACTORS SUCH AS ETHNICITY AND AGE. THE DEMAND FOR QUALITY PRODUCTS THAT APPEAL TO THE INTERESTS AND IMAGINATIONS OF THESE DEMOGRAPHIC GROUPS IS EXPLOSIVE. IN PRINT AND PROGRAMMING ALIKE, TIME WARNER HAS TAKEN THE LEAD IN SERVING THESE CONSUMERS. � L W � O O W ■ The nation's 80 million Baby Boomers (ages 35-54) spend on average 26% more per year tor information and entertainment than other age groups.' ■ Now in their peak earning and spending years, Baby Boomers form the largest population of online users in the U.S.' CNN's appointment viewing strategy, which includes Larry King Live, helped drive gains in audience delivery of Boomers. Online extensions like CNN Interactive, CNN/Sports lJ/ustrated and CNNfn allow CNN to connect to Boomers via the Internet. GG �an � a v� n a ... V, � W � . �i `- J Larger than ever and growing twice as fast as the U.S. population, the U.S. teen segment is expected to grow 13% to 34 million by 2010. Marketers increasingly recognize the power of this demographic.' Teens earned about $120 billion in 1998, up 8a/o over 1997, but exert far more power on overall spending decisions. Teens' combined direct spending and spending influence is greater than $400 billion annually.' \. With programming aimed at teen and young-aduli audiences, The , WB nearly doubled its 1998 pre- season advcrtising commitments over the previous ycar and became the onty broadcast nclwork to rcc�istcr primetimc ratinc�, gains. � U .� �/� ij . vJ � Peop/e en Espano/ became America's number-one Spanish- language magazine within a year of its debut in 1996, another successful Time Inc. brand extension. The Hispanic population is projected to grow 24% to 36 million in 2005, making it the largest ethnic minority group in the U.S.' The median age of Hispanics is 10 years younger than that of non-Hispanics' Hispanics maintain strong ties to their heritage. About two-thirds of all Latinos living in the U.S. speak more Spanish in the home than English 5 ti�+E wARNER inC ic�9tl nNNU4L REPOR7 13 1- } �; .��. A, , 'Y., r � dr��F� / / - �i, � �� i y.' �%j � ` ' y. . . i K � i r.'i if ' / 3. �� 'A � . :.e `. iF .' 4 �,J r' � .f •��T • �'l `1` �'� `�� _J` �r `_F, �;�ri� , , (,, , . �� ,, . ,,�� ; �„ �f� � �� //�i_`-,/l. � .. . ' l'��' ��1�''�i � � � / �:'Y.S�:� .. %; % �• Y ;�� i ;� •� � ' j � i ,� �, �. ;; ; : �, ; i ;�� . „ f�, , ,�, � r,,� ^,�,J / �. .' //% +��. r7 l�i�// � � � � _�..�/ ._ �� ' �J;t�� 1?'i~��. ,��f� . .., y , > � ��..�-� �� ,�� :� .4 � r 'l i � "�� ,_; 1,_ �. i'��.;.,:?� sV , i �at � _ ,� � . � �l � .' � f �l�,,; ,, _,�,+,� x..;� �/,t , ' �` ./�(},.71�3� �� .1 w �t.' .,•'� � ��l /� r4f i�'r i•�..�.' t. f . . �j��. 1� �: ' r , ��' THE EFFECTS OF TECHNOLOGY AND EVER-INCREASING LEVELS OF ECONOMIC INTERDEPENDENCE CONTINUE TO ELIMINATE OLD BORDERS AND BARRIERS. BUT GLOBALIZATON ISN'T HOMOGENIZATION. INDIGENOUS CULTURES ARE GROWIN'6 STRONGER, NOT WEAKER, AND AS INCOMES RISE, CONSUMERS EVERYWHERE qRE DEMANDING LOCAL AS WELL AS INTERNATIONAL CONTENT. THANKS TO ITS UNIVERSALLY ADMIRED BRANDS AND ARRAY OF REGIONAL PARTNERSHIPS, TIME WARNER IS STRONGLY POSITIONED TO SATISFY THE FULL SPECTRUM OF LOCAL AND GLOBAL TASTES. : '_� c � �� .� � �J r � � . .. .i� J o..��J ,�i • 'J G GG v�an :�r; _� ��J _J : � `•_.J � Nations outs�de ?he U.S. collectively spent $226 oillion in 1997 on film, music, telev�s�on and print advert�smg, outpacing U.S. sper,ding of $165 b�llion.' a International media spendin9 is forecast to grow 44% to $325 billion by 2002, a faster rate than expected in the U.S.' � Global multi-channel television advertising and subscription revenues are projected to grow 92% over 1997 to $136 billion by 2002.' . Multi-channel television subscribers outside the U.S. are expected to grow 47% to 277 million by 2002, generating revenues of about $70 billion? ■ Digital television subscribers in Europe are expected to more than quadruple from 3.7 million in 1998 to more than 16.2 million in 2005.' n ' 992 i;;�ne� �o-t:nuea ,o �-. _ �ca....cd'ceds o` �!s =��•.=�•''-,�•••;i.,� '.e!•.v9rks :r.Ih�n ey:�n5 ^r ;Jt� �„�oce a^d ,LSid .. . _r '10�v GrpC��.:•:i ! J OCd!:ZBtl . _•r�:^_^s of ^s e^:c�:2:rr-r_nt cC�i�'45 .�..i: CG :'�C' U � ' _..: � ...,��.,,_ . 1 a ... C� � U � � � J � � � Frenr!, •..CC� .'.11, �,.;�3- ..�-•� _�� a� ._ :,'a��e- '.� ., : i^.�e.n�! nr,d'�i �...,c .f�: .i_ . _ ._ ., > >�e . �-.ir:_ , ,. ,_. .,�-, �5 �8[2�. d'�.. . ...., . ..�. � . .. .. >_'ier , !1.. ... - - . � ■ Local tastes are a growing influence in the music industry, with worldwide sales of local repertoire growing 33% from 1991 to 1997.' ■ Local artists generate more than half of all recorded music sales in many countries outside of the U.S' iiME wFRnE��NC �999 c.Nr�Ua� REaOR' 15 i-_""�"•�- �: . 'r�' !'J � f _ :;;��"'� '�1� " � `�'r,' : � �y �:.s .. �� ► � /�� r E�1ZF-� /) -`;'•�...�; } ::� . �'+' �' �� , . . � 5�:�:K,'. � .�'.;� '�.,. /.:. �° �` �:i. 5 'C.. r:' � �� /�', ,.r� . �, / . .� �`rk�,�,`�,' r f �/ , .M�h � < /'. . f' t . �: F �.. [:i . . . .a;,�•.:��::_` . - �r� �� `, 'd � � `"�- , .__..__.._ {ti.;�. Techiiol oyy: THE WORLD HAS ENTERED THE DIGITAL AGE. THE INTERNET IS ALREADY CHANGING THE WAY PEOPLE WORK, SPEND AND COMMUNICATE. NEW CHANNEL CAPACITY, CABLE TELEPHONY, VIDEO ON DEMAND AND THE DVD ARE ALL MADE POSSIBLE BY THE SPREAD OF FIBER-OPTIC CABLE AND DIGITAL TECHNOLOGY. THESE TECHNOLOGICAL ADVANCES ARE EXPANDING CONSUMERS' CHOICES IN DRAMATIC WAYS. WITH A COMBINATION OF THE COUNTRY'S MOST TECHNOLOGICALLY ADVANCE^ CABLE SYSTEMS AND IMMENSE PROGRAMMING OUTPUT, TIME WARNER POSSESSES A UNIQUE CAPABILITY TO DELIVER THE SERVICES AND CONTEN7 CONSUMERS WANT THE MOST. 16 TIME v:::.'�ER INC 1990 ��:NUAL REPOR' ■ Tne U.S. Cable :�dustN�s multrbillion- do�lar upgrade w�ll bnng an array of new � and enhanced video, data and voice � offer�ngs to consumers. Approximately � 4O�'c of U.S. cable subscr�bers are served U by systems with 750 MHz capac�ty, up `rom 28��e �n 1996 and exFected to U grcv, '.o more than 60°c oy 2002.' Q■ Consumer soending on U.S. cable O serv�ces �s expected ?o grow 554% over � 1997 to $40.3 billion in 2002.' Spending L � on cable modem services is expected � to soar from $96 million in 1997 to LL $5 biilion in 2002.' H�O THE Vi�ORKS.. HBO has increased its commitment to multiplexing to take advantage of cable's expanded digital channel capacity. By May 1999, the network will offer 10 distinctly branded HBO and Cinemax channels. V 1 D E O � � .� N .� .� � In 1998 Warner Home Video's DVD wholesale domestic gross saies more than doubled over 1997 and represented more than 1 O��o of those sales for the year. ■ Following Moore's Law (costs halving every 18 months), the economics of digital technology are becoming compelling. As cable operators are able to store and deliver a vast inventory of movies at reasonable costs. video on demand will become a reality. ■ With more than 1.5 million DVD players shipped by manufacturers, the launch of DVD is s�gnificantly more successful than that of the CD or VCR at a comparable stage. GG � v�an 1 n ov�. . . e ■ The Internet is the fastest-growing segment of the media industry, with revenues projected to increase from $9 billion in1997 to $56 billion in 2002' ■ The number of online users in the U.S. is expected to grow 84%, from 63 million in 1998 to 1 16 million by 2002.' ■ E-commerce revenues are expected to rise from $7 billion in 1998 to more than $41 billion in 2002' �� W � L W � � Road Runner, Time Warner's jointly owned high-speed online service, reached 180,000 customers at year end, deliveri�g data to com- puters via fiber-optic cable and cable modem at speeds more than a hundred times faster than tele- phone dial-up services. '�M1!E �v.:R+�Ea inC �9�9 a�r.,;;,�_ 4c'OR' 17 � � � � � what I know, what I trust, what I value." IN A CLUTTERED WORLD WHERE MORE MEDIA DELIVERS MORE CHOICES TO MORE AUDIENCES THAN EVER BEFORE IN HISTORY, CONSUMERS INCREASINGLY TURN TO WHAT'.S BEST, WHAT'S RECOGNIZABLE, WHAT'S FAMILIAR, WHAT'S TRUSTED... the brands of Time Warner. HBO � � COOK'rO�F-THE-MOPlTH TI1VlE .,� � ' o �� . _ �'�� C.�i C�J�JV / I interactive �� 5111E P��n �i� �/j� \% � ��_ �,r,, ,�.,;, � �',: _/,. � �,t/ Entertain�� TIME c�� . . :..�..:.;:::,�.::::.,�...: cine ;.► Money C1W I' r iC�TIME WARNER CABLE LIFE Sports Illustrated Ru ne �..�;9hsp�On/ine A• T• O ° o 0 ��j�� N T O• K v- O O•-°- CJVV the financial necwork �� i � Headline eastwest records �� WA R N E R M US i C �rr'�asr�riod N� INTERNATIONAL �-�� y�� T � ' �� Sports � Illustrated FORTUNE � � ATLANTIC NE�' LINE CI�E�tA InStyle Elektra r�C� ��ng 1 �ESPPN�� IIMf W.RNERI:.: '�yJH:�\"..'_ -..-^�1 �9 Time Warner's Cabie Networks group is home to many of the most ��;.lu- able franchises in television news and entertainment, including CNN, the world's foremost news brand; HBO and Cinemax, the nation's two leading premium cable networks; and many of the best-known brands in television ente�tainment, including TBS Superstation, TNT, Cartoon Network and Turner Classic Movies. Turner Entertainment Networks CNN News Group Home Box Office New Line Cinema Turner Entertainment Networks With a steady supply of quality pro- gramming provided by Warner Bros., New Line Cinema, Castle Rock Entertainment, the vast Time Warner film and animation libraries, and other leading suppliers, Time Warner's basic- cable entertainment networks gener- ated strong growth in subscription and advertising revenues. The superior pro- gramming is attracting an increasing share of television viewers from broad- cast networks to cable and driving greater distribution of the Turner enter- tainment networks. The Turner entertainment networks are leaders in virtually all key demo- graphic segments. TBS Superstation, which converted to a copyright-paid basic-cable channel in 1998, is a e e tw� �Tofi ro�v, lrorn lef!) Ct,!I:.�on Ne.v;orE: s ne�•: origin�l series The Porierput( Grrls has hce:i thc nehvork'S highest-rated primetime series since its pren-�iere in Nove:nber 1 998. HBO's new series. 7he Sopnno;, starring lames Gandolfini, is a drama about a mob boss in the midst of a midlife crisis. CNN's Christiane Amanpour is one of the world's most renowned television news �orrespondents. (Boftom ro�v, from leftl Lost rn Space, based on the popular television series, was one oF four New Line Cinema movies renked among 1998'S 26 highest-grossing films at the domestic box office. Halle Berry stars in Dorothy Dandridge, HBO's biopic to be released in 1999, about the life and tragic early death of the legendary actress. Undefeated welterweight champion Oscar De La Hoya is one of the top boxers to appear on HEiO. In addition to fashioning a new on-air look for the network, CNIJ/U.S:s newsroom and studio renovation features a sigr,i(icant upgradc in technology. 2O TIME WARNER INC. �998 ANNU�L REPORT watched by more people than any cable network and leads the total-day delivery of adult demographic audiences. TNT, basic-cable's leader in primetime delivery of key adult demographics, reached a distribution milestone in 1998- �75 percent of U.S. television homes=just 10 years after its launch and sooner than any cable network in history. TNT joins CNN and TBS Superstation as three of only six basic- cable networks to have achieved this level of distribution. Turner's strategy of aggressively acquiring broadcast network premiere rights to contemporary motion pictures for deb�t on TBS Superstation and TNT continued to prove successful in 1998. TBS Superstation's world broadcast premiere of The American President delivered the largest audience J1 3�, :�CG ' C3 m�.�� .�3: C'=dC = histcr�. ir 1998 ?BS S��e�sz- o� a�,c TNT acqu�red `.he oroaccas° � o�'.s �� sucn t�'les as 'J�arrer &os. �oc, .e i;c; Ma,l an� L.A. Conf-aen; a;: Ne:•, L ne C��nema'; T�e b^✓edd,n�7 J�^ce� :^d P;e3sv��. -. as :;e�; as ��,•_ o,_�...cec bv o:her e=c �_ _uo�i�e�s. �c._c �,y �+s Good As 1! GA�� GrC T1� �Y�CJK ;j� LO��O. The fas�-gro�vmc Car,00n Ne:.vor'�. which passed the 50-million mark in U.S. subscribers �n 1998. �s seen �n a regionalized form in more than 70 mil- lion homes in 120 countries ou,side the U.S. For the vear, Cartoen Network was the second-highest-rated ad-sup- ported cable network in the U.S. among kids ages 2 to 1 1. Tumer Classic Mov�es (TCM) grew its household dis;ribution by nearly :J �t'�.:_. � ��'J� d^u �., °�� __ =�e tnan 30 m:�i;on U.S. suoscr�oe�_. �� ,e *r��rc o�nseo.,'��e ;eac a oerch- ^��ark surve�, or ca�ie oaer?tors p�aced ICti1 3:'ne CoN C� T� :�i 0' moS�- .N.CSif°.�. "1P'i� rE �:JG'�(c. if1iB��2ii0^dl p�e'3;'0�5 DidY 8^. mportan: ro�e ^ ?ne success oi ;he Tumer en`,er;zirmer.? net:�ork;. In 199$ the cor,pany continued to launc�� local�zed feeds of its enterta�nment netwcrks �ithir regions of ooth Europe and As�a. Tumer now crocuces t 5 local�zed versions of �ts enter�ainment retworks �n coun�nes outs�de the U.S. Turner entertainment ne:�✓orks more than 10 World Wide Web s�tes comple- ment network programs and osfer cng�nal conten; exclusive to the Web. �� -� ,,�Y -,.,, � � _� _.. _ .. _ _- .; de ^d: nC aC.��: . : �'�� _� . : _. CIVN CG�; nu25 '_ a.�3^;� .- --••� 2: '3��,i52. B.:',C:� J.^. ." S� .. c.._..- � =.�� a�„ ne�:._ ...,�.e�aoa. C��;�� ^�,ar"» z ac ��'�,;!� oopo�t�n��es �. aoc��c exc�t ng �e:, orograr,m,inc " the U.S.. expana��no ��to ne:�, -ea��or= �n±emat�onally and de>e�op�ng ne�r� d�g�tal and �nte�ac+.�ve ne�,vs pla"orm.s. U.S. cable telev�sion v!ewers ence aga�n made CNN the�r r.e�.vs neT�.ork of choice �n 1998. The net�vork �os:ed househoid deliver� �ncreases o` 20 pe�- cent �n to?ai day and 21 percen; �n pnme time. With more'h2n '15 ^'�'I o'� subscribers in the U.S.. CNN s t`e number-one-distr�bu:ed ^e.�s ��er:;o.� 'ollowed by CNN Headl�ne Ne::s. '��E'A�,cR��e4�r�C ��.:g�•.�.,�,:_;E��Rr 21 rvn�Cn passed 'he 70-million-su�scriber mark �n 199$—the fourth Tumer net- work (af,er CNN, TBS Supersiation and TNT) to do so. Bevond �ts unmatcheo coverage of 'oreaking news. CNN's s'.ra'egy ?o create regularly sched.,��ec s�gnature programming, documen,2r.es anc ne�.vs specials that drive appo�ntmen; vie�Ning is expected bo,h to contribute to the growth of the network and to broaden its demographic base. In 1998 CNN launched NewsStand. a weekly pro- gramming franchise combining the joumalistic strengths of CNN with Time Inc:s Time, Fortune and Entertainment Weekly. CNN also premiered Cold War, a landmark, 24-hour documentary series featuring commentary from more than 500 eyewitnesses who either helped shape Cold War policy or whose lives were shaped by it. CNN �s meeting the grow�ng �nter- nat�onai demand for news programming with a reg�onalization strategy that was exoanded �n 1998 to include s�x news and bus�ness programs produced excius�ve'��v `or As�a from tne net�r�o�k�s Hong Kong bureau, and three new o�_:s�ress programs produced exdus�vely for Europe. In 1999 CNN launched CNN+, a 24-hour Spanish-ianguage news network, jointly owned by Turner and Sogecable, S.A.. for distribution in Spain and Andorra. CNN Intemational reaches 140 million television house- holds in 212 countries and territories— more viewers than all other cable news services combined. CNN Newsource's unmatched network of broadcast affiliates climbed to more !han 580 in 1998—nearly 70 percent of all news-producing stations �n !h@'�l.s. 3nd Cd�dCd. '�i '2�di''�5 the most N�dely synd�cated oomest�c telev�s�on news-feed ser��ce. The grow±h of new netsvorks �s alsc suei�ng the expans�on or the CNN oranc wor!dvnde. These brand extens�ons �nC!ude CNN/Sporrs Illustra*ed. the 24-hour spor*,s-news ne`�vork crea'ed �omtly w�th ±he Time Inc. magaz�ne: CNNfn, the only cabie ne!sro�k to offer contmuous primetime busmess news coverage; and CNN en Espanoi. the leadfng 24-hour Span�sh-language news network �n Latin Amenca. The launch of these three new net- works on digital platforms, the upgrade of CNN's ne�.vsroom and stud�o in Atlanta. and CNN's increas�ng presence on the World Wide Web are sure signs of CNN's technologica! leadership. CNN's interactive services are the most vis�ted 22 ne+E waRNER ihC. '998 .oNnUAL RE°ORT news and information sites on the Web, with more than four billion pages viewed by CNN users worldwide in 1998. Home Box Office Award-winning and popular programs continue to attract new audience, to Home Box Office, America's most successful premium television network. Its two 24-hour services—HBO and Cinemax—grew to 34.6 million U.S. subscribers at year end. HBO services also reach nearly 1 1 million subscribers in more than 40 countries in Latin America, Asia and Central Europe. The network's continuing growth is a direct result of its powerful prog�am- ming that drives subscriber acquisition. With the best blockbuster movies from Hollywood and innovative original pro- gramming, HBO is the highest-rated cable service during the day and in prime time. Cinemax, the second-high- est-rated cable service, features more than 1,600 movie titles a year—more than any other pay service. HBO's original programming attracts the best talent in Hollywood. In 1998 HBO premiered the Emmy Award- winning miniseries Fiom the Earth to the Moon, executive produced by Tom Hanks, which drew more than'47 mil- lion viewers during its six-week run. The network's next miniseries project, Band of 8rothers, will be exe�utrve produced by Hanks and Steven Spielberg and is slated to air in 2000. HBO's widely acclaimed series include Sex and the Cify and Oz, and its newest hit, The Sopranos. HBO original movies, which have won the best-movie Emmy for.the past six years, explore topics as diverse as the Uetnam War in A Bright Shining Lie, and Frank Sinatra and his famous friends in The Rat Pack HBO's 1999 movies include Lansky starring Richard Dreyfuss, A Lesson Before Dyrng with Don Cheadle, and Dorothy Dandridge featuring Halle Berry. HBO also produces award- winning documentaries, and its unparal- leled lineup of fights makes it the leader in professional boxing on television. In 1998 HBO won 14 Primetime Emmy Awards, more than any other cable service, including best miniseries, and best movie for pon King: Only in America. In 1999 HBO won five Golden Globe Awards, more than any other cable service, including best miniseries, and best actor and best actress in a movie made for television. HBO also received three Academy Award nominations. In 1998 Home Box Office increased its commitment to multiplexing to take advantage of expanded digital channel capacity. HBO now offers four channels (7op row, trom left) New Line Cinema's Rush Hour, starnng Chris Tucker and lackie Chan, was among the 10 highest-gross- ing movies of 1998 at the domestic box office (5147 million). The Atlanta Braves, with star pitcher Tom Glavine, captured the National League's Eastern Division crown in 1998. (Bottom row, from lek) The TNT Original film Purgatory, a 6Vestern drama starring Sam Shepard. set viewership records as the most•watched original movie in basic•cabte history. TBS Superstation's WCW Thunde� featuring wrestling superstar Bill Goldberg, consistently ranked among the highest-rated cable television pro9rams of 1998. Turner Classic Movies features themed film festivals. speual star salutes, engaging original documentaries and more than 350 movies each month, like the MGM classic On Tlie Town. designed to appeal to a variety of viewing tastes: HBO, HBO Plus, HBO Signature and HBO Family. Two addi- tional channels, HBO Comedy and HBO Zone, will launch in May 1999. With the most extensive film inventory in pay tele- vision, the network also offers four all- movie charinels: Cinemax, MoreMAX, ActionMAX and ThrillerMAX. In addition, HBO began high-definition television (HD11� service in March 1999. New Line Cinema In 1998 New Line enjoyed the best year in its history, registering all-time records for domestic box-office grosses and for video and television sales. New Line's films refresh Time Warner's libraries and provide valuable programming for the company's cable networks. Contributing to New Line's out- standing performance were four of the year's 26 top-grossing films at the domestic box office: Rush Hour, The Wedding Singer. B/ade and Lost In Space. Rush Hour, which grossed $141 million at the domestic box office in 1998, set a new opening weekend record for New Line. Three other New Line films—Blade, Lost in Space and Pleasantville—were the highest-gross- ing films on their respective opening box-office weekends. TIME M�AR\=R INC. i99B ANNUAL REPORT '13 Time Inc. is the foremost creator of publishing and information brands, including many of America's most successful magazines, best-selling books, popular book clubs and Internet sites. It is also a leading direct marketer of books, music and video. Time Inc.� Powered by its diversified portfolio of renowned brands and franchises; Time Inc. posted another year of strong doub!e-digit operating growth in 1998. Employing its strategy of core product investment and brand extension, Time Inc. continued to achieve advertising growth, generate circulation gains in both subscriptions and newsstand sales, and launch promising new businesses. Advertising revenues, as measured by the Publishers Information Bureau, grew 9.6 percent at Time Inc:s con- sumer magazines in 1998, outpacing the industry. Time Inc. accounted for 21.1 percent of total advertising revenues generated by consumer mag- azines in the U.S. in 1998, with People, Time and Sports lllustrated again tak- ing the three top revenue spots. In addition, Forfune, which had its fourth consecutive record profit year in 1998, advanced into the tOth position. Sporfs lllustrated, which underwent a major redesign, set another record for adver- tising revenue. At the core of Time Inc:s success is - rich tradition of journalistic integrity dating back to Time magazine's found- ing. Time celebrated its 75th anniver- sary in 1998, a year in which the magazine achieved solid gains in circu- lation and advertising revenue. Time Inc:s strategy of extending its well-established brands to a variety of underserved audience segments has contributed to significant growth. Leading the way in 1998 was Teen People, one of the most successful magazine launches ever. After its first year, Teen People's rate base had grown 140 percent, to 1.2 million with its February 1999 issue. Within the teen • • u ls ln 24 -� ._ WARNGR I�VC 'ogd �'JNV�.L REPORT category, Teen People also secured the number-two position in both newsstand sales and prestige beauty advertising, a critical indicator of advertising vitality. In Sfyle, which evolved from the People franchise, continues to carve out a strong position in the fashion, beauty and celebrity-lifestyle category. In Style's rate base grew from 800,000 in 1997 to 1.1 million in January 1999. Another brand extension, People en Espanol, became America's number- one Spanish-language magazine within a year of its debut in 1996. Launched as a quarteriy, People en Espanol increased to ten issues a year in 1998. Fueled by advertising revenue and rate base growth at Parenting maga- zine, the Parenting Group had a record year. It expanded its distribution chan- nels by acquiring First Moments, Inc., a leading sampling company targeting new and expectant parents. Entertarnment Weekly on Campus, an extension of Time Inc.'s popular weekly, has experienced strong growth since its 1997 launch. One million copies of the magazine are now distrib- uted in 100 leading college newspapers. The magazine titles of Southern Progress Corp., Time Inc:s preeminent regional publisher, enjoyed another successful year, led by increased ad revenues from Southern Living, Cooking Light Weight Watchers and Coastal Living. Sunset which celebrated its t00th anniversary in May 1998, also had significant gains for the year. Beyond creating innovative strategies for reaching demographic audiences, Time Inc. is a leader in developing tech- nology and industry innovations that enable it to produce and distribute its magazines more efficiently. For example, Time Inc. moved up the delivery of People to checkout counters in time for the weekend, when consumers do most of their shopping. This strategy led to significant increases in the magazine's already solid newsstand sales. Time Inc. is bringing its unique brand of journalism overseas. In early 1999, Time Inc. and German publisher Burda Holding GmbH agreed to publish a German-language edition of In Style in Germany, Austria and Switzerland, while in 1998, Fortune and Time expanded their publishing ventures in Latin America. Time Inc:s joumalistic and information- based expertise has served as the basis for an aggressive expansion into broad- cast and cable programming, including its collaboration with CNN on CNN/Sports lllustrated, the 24-hour sports-news net- work, In 1998 NewsStand, a weekly programming franchise, was launched, combining the journalistic strengths of CNN and Time Inc:s Time, Fortune and Entertainment Weekly. Direct marketing at Book-of-the- Month Club (BOMC) and Time Life accounts for a significant portion of Time Inc's revenues. BOMC continued to enjoy solid revenue growth in 1998, fueled by the success of Children's BOMC, the One Spirit book club and the growth of its women's lifestyle clubs. With some of the most-visited Intemet sites, Time Inc. is well positioned to capitalize on this fast-growing medium. Among other initiatives, Time Inc. is helping spearhead Time Warner's efforts in electronic commerce, where Time Inc. will draw on its vast direct-marketing expertise and resources in database management, customer service, fulfillment and warehouse operations. (From lefr) "The Time 100: leaders and Revolutionaries" is one of a series of six special issues profiling the most infiuential people of the century as chosen by Time's editors. Enlertainment Weekly, winner oF three 1 998 National Magazine Awards, celebreted its ninth consecutive year of ad page growth. and this year its guaranteed circulation reached an all-time high of 1.4 miilion. Southern Living posted its 33rd consecutive year of profit growth and ranked 12th in advertising revenues among monthly magazines in 7 998. Time Warner Trade Publishing placed 31 books on The New York Times best-seller lists in 1998 from its Warner Books and Little. Brown imprints. Littte. Brown's When the Wind Blows, a new thriller by James Patterson, topped the best-seller lists in the fall of 1998. Warner Books' Message in a Bottle by Nicholas Spa�ks spent 28 weeks on The New York rmes best-seller list in 1998. The movie version was released by Warner Bros. in February 1999. Teen People, one of the most successful launches in magazine publishing history, grew from a guaranteed circulation of 500,000 at its debut to 1.2 million with its February 1999 issue. Time-Life Music successfully launched several new series, including the best- sellers Songs 4 Lile and Classic Country. TIME WARNER INC. �998 ANNUAL REPORT 2.S ntertalnm ent Time Warner's Entertainment businesses consist of Warner Bros., a global leader in the creation, distribution, licensing and marketing of movies, television programming, video and related products, and Warner Music Group, the world's most diversified, vertically inte- grated music company with a world- wide roster of established stars and new artists. Warner Bros. Warner Music Group Warner Bros. Founded 75 years ago as a motion picture studio, Warner Bros. has evolved into a fully integrated, global entertain- ment company that relies on businesses such as feature films, television, anima- tion and product licensing to achieve strong growth. Warner Bros. has been the leading supplier of primetime television pro- gramming for 12 years running. A strong lineup of network series, including ER, F�iends, Ve�nica's C/ose� Suddenly Susan, Jesse and The Drew Carey Show, coupled with a powerful off- network syndication pipeline and such first-run syndicated hits as The Rosie 0'Donnell Show, provide Warner Bros. with a foundation for growth into the new millennium. In the largest produc- tion agreement for a series in television 2G TIME WARNER INC. 1998 ANNUAL REPORT history, Warner Bros. and NBC signed a three-year deal in 1998 for new episodes of the number-one-rated ER. Capitalizing on the growth of the teen and young-adult demographics, The WB Television Network was the only broadcast network in 1998 to generate a primetime ratings increase over the previous year. A strong roster of hit shows like Buffy the Vampire Slaye� Dawson's Creek, Charmed, Felicity and 7th Heaven—that appeal to the young audiences coveted by advertisers—enabled The WB to nearly double its 1998 preseason commit- ments from advertisers. Known worldwide as the creator of some of the most powerful franchises in movie history; Warner Bros. also con- tinues to produce successful movies in film genres that appeal to a broad range of audiences. With the addition of 1998 box-office successes such as Lethal Weapon 4, City of Ange/s, A Perfecf Murder, Pracfical Magic and You've Got Mail, Warner Bros. has � enhanced its quality library of motion picture entertainment The vast library, which includes 5,700 feature films, 32,000 television titles and 13,500 animated titles, is continually reintroduced to the world through Time Warner's cable networks Warner Home Vdeo and through dire distribution to traditional and emergin television media The library has also provided the foundation for the ex- pansion of Warner Bros. Worldwide Consumer Products, one of the (Filmstrips, liom !e/t) Warner Bros: 1998 box-office successes included City of Angels, starring Nicolas Cage and Meg Ryan; Letha/ Weapon 4, which reunited Mel Gibson, Danny Glover and Rene Russo: and You've Got Mail, with Tom Hanks and Meg Ryan. (Television screens, c/ockwise from top left) Classic Warner Bros. characters Sylvester and Tweety were featured on the most popular U.S. postage stamp of 1998. IWamer Bros. Television's current hit comedy series Friends began its off-network syndication in 1998. Thanks to youth-oriented hits like Dawson's Creek, The WB was the only broadcast network in 1998 to generete a primetime ratings increase from the previous year. Warner Bros. Television's ER is America's most-watched television series. �Warner Bros.Television Animation's 8atman Beyond is the highest-rated series on the Kids' WB! The Drew Carey Show, the highly rated comedy from Warner Bros. Television, goes into syndication in 1999. �The Rosie 0'Donnell Show fuels Warner Bros: powerful first-run syndication lineup. leading builders of brands, through its of its films, decreasing its financiai risk licensing and merchandising activities while retaining, in most cases, world- as well as through its more than 180 wide distribution rights. innovative, wholly owned or franchised With 34 percent of its total revenues Warner Bros. Studio Stores in 15 coun- tries and territories. Emerging technologies, such as DVD, are providing additional platforms for the distribution of Time Warner's library product. DVD, offering superior picture and sound quality, convenience, exciting interactive features, viewing options and an affordable price, was rolled out in August 1997. Based on the volume of players shipped, DVD's launch is significantly more successful than that of the CD or the VCR at a comparable stage. In response to the rising cost of producing theatrical films, Warner Bros. signed joint-venture agreements with several companies to co-finance some coming from outside the U.S., Warner Bros. continues to expand its interna- tional businesses. In 1998 it formed a joint venture with Nippon Television Network, Toshiba and Time Warner Entertainment Japan to produce and distribute movies and television pro- grams in Japan and worldwide. Warner Bros. also established production arms in Germany and Asia to co-produce and acquire indigenous theatrical films for both locat and worldwide distribution. Warner Bros. International Theatres is increasing its joint venture presence in the United Kingdom, Italy and Taiwan, and expects to have more than 950 movie screens open by the end of 1999. TIME WARNER INC. 1998 ANNUAL REPORT �I% World•renowned artists from Warner Music Group's record labels �nclude: (Top row. `rom leftl Busta Rhymes lElektral and Cher �Wh11/Warner Bros. Records� (Middle row, irom lefU Morcheeba lSire/WMU. Laura Pausini (WM11U. Third Eye Blind (Elektrai. lewel (Atlanticl. and Madonna �Nlamer Bros. Recordsl !Boftom roVi. f.•om IefU Brandy +Atlant�cl and Barenaked Ladies (tiUarner Bros. Records) 28 '�',�c >vaRr,ER :�:C '�99P a�in�U�L REPORT ;;.3rne� �.1cs•c ��c,:c Aided by a powerful slate of new releases, the continuing recovery of the U.S. retail music business and a growing presence overseas, Warner Music Group regamed its positive momentum in 1998, postirg �mproved financiai results. In 1998 Warner Music Group accounted for 23 of the year's 100 best-selling albums in the U.S., with 20 selling a million or more units. The Music Group's share of U.S. album sales was 19.8 percent, as measured by Sound Scan. Top domestic sellers included the City of Angels soundtrack and releases from matchbox20, Brandy, Madonna, Barenaked Ladies, Jewel, Alanis Morissette, Third Eye Blind, Metallica, LeAnn Rimes, Eric Clapton, Goo Goo Dolls, LSG and Natalie Merchant. Internationally, top sellers included Madonna, Enya, Alanis Morissette, Phii Collins, Eric Clapton, The Corrs, Alejandro Sanz, Simply Red, R.E.M.; Luis Miguel; Laura Pausini and Mike Oldfield. The multinational, multicultural appeal of the music produced by Warner Music Group's record labels— Warner Music International, Atlantic, Elektra, Rhino, Sire, Warner Bros. Records and their affiliated labels—is at the core of the Group's turnaround. In 1998 more than 52 percent of the Group's recorded music revenues came from outside the U.S. With local reper- toire now accounting for 50 to 70 per- cent of music industry sales in many countries, Warner Music International— with a roster of more than 1,000 artists—is expanding its efforts to sign local artists and devoting greater resources to marketing U.S. artists overseas. WEA Inc. also contributed to Warner Music Group's 1998 success. The three companies that make up WEA Inc. are each among the industry lead- ers m the U.S.: WEA Corp., the leading U.S. music-distribution company in the industry in 1998; WEA Manufacturing, one of the world's largest CD manufac- turing companies; and Ivy Hill, producer of award-winning printing, packaging and graphic design. Warner/Chappeil, one of the world's leading music publishers, is vital to the Music Group's global strength. Warner/ Chappell, which controls more than one million copyrights, was named ASCAP Pop Publisher of the Year in 1998. The growth of recorded music sales via the Internet has provided the Music Group with a new way to reach con- sumers in 1998. Online music retailers carry vast music inventories and appeal to consumers interested in music but less likely to shop at traditional retail outlets. As data transmission capabilities increase and music security standards are adopted, the digital distribution of music via the Internet offers tremendous potential to expand music sales. Consequently, Warner Music Group labels have established a major online presence and are marketing music in creative ways. Atlantic was the first label to create an online studio, offering cybercast performances by such artists as Tori Amos, Duncan Sheik and Jewel. Elektra signed up 12,000 people for a listening party for Metallica's latest album, Garage Inc. And Warner Bros. Records has enrolled 50,000 music fans per week following the recent launch of its Web site, www.musicinformation.com, which notifies fans of the activities of their favorite Warner Bros. Records' artists. DVD Audio, expected to launch in 1999 and offering dramatically improved stereo and multichannel audio quality as well as advanced copy-protection features, is another technology with the potential to have a positive impact on the music industry over the next decade. II, , z .y -- < :;; ;> �� , ;� := �. _ =� =� � -:� f��lt -"� . �_ . �Top to bottoml WarneriChappell com trols more than one million mus�c copy- rights and publishes sheet music from a wide variety of artists in its extraordinary catalogue. including classics from George and Ira Gershwin along with works from such hitmakers as Green Day and the legendary Eric Clapton. WEA Inc.. in addition to its leadership role in manufacturing. packaging and distributing music. is the world's largest producer of DVDs. Rhino Records, the world's !eading reissue label, released neariy 200 new compilations and box sets in 1998. The Burt Bacharach Collection was Rhino's biggest selling box set for the year and Millennium Funk Party its best-selting compilatio�. TIME wARNER INC �998 �r1n:�.a� aE�ORT 29 Time Warner Cable is the nation's largest owner and operator of cable systems. Its cable systems are also the world's most advanced and best-clustered, with 82 perce�t of its 12.6 million customers in systems of 100,000 subscribers or more. Time Warner Cable Aggressively pursuing its strategy to. upgrade its cable systems, Time Warner Cable is solidifying its position as the technological leader of the dynamic cable industry. It is a pioneer in bringing the digital age into America's living rooms and transforming the way Americans receive information and entertainment The additional capacity of its upgraded systems provides the foundation for continued growth and is powering the company's expansion into exciting new business areas. Time Warner Cable's substantial investments in fiber-optic system �,:grades and new digital technology enable customers to receive more and better programming, enhanced picture and sound quality, improved signal reli- ability and advanced telecommunications products and services. These products and services include new cable net- works, multiplexed premium channels, new digital program tiers and pay-per- view options, high-speed online service through cable modems, cable tele- phony, and more local programming. By the end of 1998, Time Warner Cable had upgraded approximately 70 percent of its cable plant. Completion of the upgrades is targeted for year end a e � ste ms 3O TIME WARNER INC. 1998 qNNUAL REPORT 2000. The additional capacity created by the upgrades provides enough bandwidth to carry digital television (including high-definition television [HDN]), high-speed data transmission and residential telephone. service. Even with the addition of these services, substantial capacity has been reserved forfuture use. Time Warner Cable continued to roll out Road Runner'", its jointly owned high-speed online service, launching the service in five new locations in 1998. The Road Runner service, named after the famous Warner Bros. cartoon character, was strengthened through its combination with MediaOne's high- speed online service and through investments by Microsoft and Compaq. Road Runner, with 180,000 customers ano access ;o � m�llion cable homes at year end, connects customers to the Internet at speeds more than a hun- dred times faster than telephone dial- up serv�ces. It also o`fers access to local ;nformation and unique content from a wide variety of leading sources, including Time Warner's vast number of World Wide Web sites. In 1998 Time Warner Cable began commercial testing of the next genera- tion of advanced digital set-top boxes, whiCh will offer Consumers new program tiers, more channels of multiplexed pre- mium services, an interactive program guide, parental lockout features, VCR programming and near video-on- demand capability. An aggressive national rollout of the first phase of the new digital service will begin in the first half of 1999. At the core of this rollout �s Time Warner Cable's AthenaTV digital satellite feed, wh�ch will be used to provide up to 100 d�gital program networks. When combined with existing digital feeds from HBO and other premium services. as +vell as Viewers Choice, AthenaN will enabie Time Warner Cable to offer customers about 150 channels of analog and digital video, plus a multi-channel digital audio service. The planned addition of video servers at Time Warner Cable systems will make it possibie for the company to offer the second phase of its digital services, enabiing set-top boxes that operate in a full video-on-demand environment, including virtuat VCR functionality, with pause, fast-forward and rewind functions. In a demonstrat�on of �ts bei�er tha[ di9ital television will revolutionize the television-viewing experience. T�me Warner Cable has agreed to carry HDTV and other digital signals of CBS-owned television stations. the first such agreement between a major cable operator and a television broadcaster. Time Warner Cable increased its commitment to the communities it serves through the launch of 24-hour local news channels, announcing that it will debut the first local all-news cable channel in Austin, Tex., in the spring of 1999. The channel will be the fifth local cable news channel for Time Warner Cable, which operates such channels in New York City (NY1 News), Tampa Bay, Fla. (Bay News 9), Orlando, Fla. (Central Florida News 13) and Rochester. N.Y. (R/News). F.•om 'e`:� F•oduced by Tir+�e �lJarner Cab�e ccal r,z�vs �•cgra�^r�:ng. ;i4e Bay News 9�r 'ampa Ba�. Pla.. mcreases �xai advert�s�ng r?ve.^.ues and value to subscr�bers. Ir;eraciive program gwCes enable v�ewers to search for. select and purchase program- m�ng based on detailed prcgram descript�ors. T��e SVarner Cabie !aunched ,s �ointly o�.vned Road Runner " high•speed orline service +n five new locations �n ? 998. Expanded pay-perview aphons are among the added sero�ces made possible by T�me Ylarne� Cableb upgraded cable systems TIME WARNER INC �998 ANNUAL REPORT 3i � � � � �an re su s. Financials 34 FinancialOverview 38 Financial Highlights at a Glance 39 ManagemenYs Discussion and Analysis of Results of Operations and Financial Condition Consolidated Financial Statements: 58 Balance Sheet 60 Statement of Operations 61 Statement of Cash Flows 62 Statement of Shareholders' Equity 63 Notes to Consolidated Financial Statements 92 Report of Management 92 Report of Independent Auditors 93 Selected Financial Information 95 Quarterly Financial Information 'iA'= �•.:�RNLR �NC 1996 ANNUAL K='(J�i 33 Financial Overview Time Warner, together with the Entertainment Group, achieved another record financial performance in 1998. This performance was driven by solid growth in all our businesses and a disciplined financial focus on cost man- agement and controlling capital spending. As a result, we generated free cash flow that enabled us to continue to strengthen our balance sheet and increase our financial flexibility. This performance led to the achievement of a solid investment-grade credit rating, which was one of our key ---- financial goals for the year. Going forward, our principal financial objectives are to continue to achieve sustainable operating growth, hold capital spending steady and further reduce costs. By accomplishmg these objectives, we expect to continue to accelerate our return on capital and generate increasing amounts of free cash flow. We intend to use this cash and financial capacity to repurchase stock and invest in the growth of our busi- nesses, while maintaining our solid investment-grade credit rating. Achieving Sustainable Operating Growth Time Warner had an outstanding operating performance in 1998; whether measured by growth in normalized revenues, operating income before noncash amortization of intangible assets ("EBITA"), or improving, bottom-line per share performance. We focus on "normalized" measures in order to communicate underlying operating trends. These normalized results exclude the effects of certain cable-related transactions and significant nonrecurring items that occurred in 1998 and 1997. All of these are described more fully in Management's Discussion and Analysis. Time Warner's combined revenues increased 1 1% on a normalized basis in 1998, to approximately $26.8 billion. This revenue growth contributed to a 14% increase in EBITA on a normalized basis in 1998, to approximately $4.5 billion. This strong 14% EBITA growth rate, which was achieved despite a transition year for the Music segment of our Entertainment operations, demonstrates one of the benefits provided by our collection of integrated businesses. While our Music business achieved 6% EBITA growth during the year, all of our other businesses delivered solid, double- digit EBITA growth. This growth was led by a 20% growth rate for Cable Networks, 17% for Filmed Entertainment, 15% for Publishing and 14o/o for Cable. 34 TtnnE wARNER iNC i99R aaNUAL RfPOR; Combined Revenues (millions) $2a,s22 $23,660 1996 1997 Pro Forma�a> Combined EBITA (millions) $4,033 $3,342 1996 1997 Pro Forma�a� 1998 1998 1998 Combined EBITA by Business Segment�b� $4.462 Million Time Warner achieved 11%growth in revenues in 1998 on a normalized basis. Tme Warner achieved 14�/o growth in EBITA in 1998 on a normalized basis. --___Cable Networks 26�/0 __ _ __.__Publishing 13% _____Entertainment 24�/0 ---- Cable 37�/0 Time Warner's collection of integrated businesses provides increased economic stability. (a) ReHects fhc lufl�yea�, pro lorma ellect ol �he 7BS acpuisifion. (b) Percenrages calcula(ed Gefore mfercompany eliminations. In addition to fundamental business growth, Time Warner's 1998 combined operating performance was enhanced by the effects of a company-wide cost manage- ment program, which began in 1997. The program's purpose is to control costs by identifying more efficient ways of conducting our businesses. In 1998, we realized over $450 million of incremental cost savings, thereby increasing the aggregate cost reductions under this program to over $600 million annually. As we continue to roll out and expand this program, we expect our annual cost savings to increase to $800 million by the end of 1999. Our continuing focus on the bottom line, together with the fundamental operating growth of our businesses, resulted in a significant improvement in normalized loss per share from a$.33 loss per common share in 1997 to a$.06 loss per common share in 1998. We expect to continue this improvement into the future and anticipate reporting positive earnings per share in 1999 for the first time since the Time- Warner merger. Controlling Capital Spending Even while we continued to make significant progress towards completing the technological upgrade of our cable television systems, we held combined capital spending flat in 1998 at $2.1 billion. Cable-related capital spending also was held flat in 1998 at $t.7 billion. Overall combined capital spending is expected to remain essentially flat through the year 2000, when we are scheduled to substantially complete the technological upgrade of our existing cable television systems. Thereafte�, we anticipate a reduction in capital requirements for these systems. As of the end of 1998, approximately 70% of our cable television systems had been upgraded. Maintaining Debt Levels and Improving Capital Structure During 1998, Time Warner generated approximately $2 bil- lion for debt reduction. This increased our financial flexibility and allowed us to replace approximately $2 billion of 10%% Series M preferred stock with lower-cost debt, while holding our overall debt levels steady. As a result of this refinancing, we expect to save over $100 million of cash annually beginning in 1999. Our improved financial flexibility and operating perfor- mance contributed significantly to our stronger combined Cost Savings (millions) $150 . t997 1998 Combined Capital Spending (millions) TCTAL $2.303 To-A= � $2.139 y�� caa�e C<9L` $1.563 ��•saa I �996 t99� 1998 Pro FOrma<<� Time Warner's cost management progrem has reduced embedded costs by over $600 million annually. Capital spending was held flat in 1998 and is expected to remain so through the year 2000. (c) Rellects the li,q.,e�r, o,u lonn:� ellecr ol the rBS acqu�s�oon. �vr.r.u�nirvc ��=w.�,r�nur,i r.ero;- 35 financial condition, as reflected in our combined financial rati.,s. These ratios, consisting of commonly used financial measures such as leverage and coverage ratios, reflect our improved ability to repay debt (leverage) and to pay interest and preferred dividends (coverage). This improvement was recognized by both Standard & Poor's and Moody's in 1998 and resulted in our upgrade to a solid investment-grade credit rating. This solid investment-grade credit rating is consistent with our capitalization goal of achieving the appropriate bal- ance between debt and equity that is expected to minimize Time Warner's weighted-average cost of capital, while, at the same time, providing financial fiexibility and continuous access to the capital markets. We believe that the tinancial leverage implicit in our credit rating is beneficial to our shareholders because it optimizes our weighted-average cost of capital, thereby creating value for our shareholders. To continue these benefits into the future, we are committed to maintaining our investment-grade credit rating. Having achieved this significant milestone, we are moving into the next phase of our financial plan. This phase will allow us to use our increasing free cash flow and financial capacity to.repurchase common stock and to continue to invest in the growth of our businesses. Repurchasing Common Stock During 1998, we continued our common stock repurchase program. So far, we principally have used our stock option proceeds credit facility, in effect, to accelerate the receipt of proceeds from future stock option exercises. These funds enabled us to repurchase stock at current prices, rather than at the higher prices we expect in the future. The repurchased shares are then used to satisfy subsequent stock option exercises and the conversion of certain convertible securities. Since the commencement of this program in April 1996 through the end of 1998, we have acquired approximately 95 million shares of common stock at an average purchase price of $32 per share for an aggregate cost of approxi- mately $3 billion, including $2.2 billion in 1998. Comparing repurchase prices to market values at the time of any subse- quent issuances or at February 28, 1999, the program has created incremental value for our shareholders of approxi- mately $1 billion. In 1999, we are significantly expanding our stock repur- chase program to cover the purchase of $5 billion of common stock. This plan is expected to cover repurchases made over the next three years. The principal funding for this program is .�6 'IME WARNER INC 1998 ANNUHL REPORT Combined Leverage Ratios � a.�x U Z 32x Z ' � � isss�a> iss� �9ss Combined Coverage Ratios Interest and Preferred Dividends � U � w 2.ax Z 2.3x G � 1996�e> 1997 1998 Time Warner continued to improve its financial ratios in 1998, as reflected by reduced leverage and increased coverage. Common Stock Repurchase Program (billions) $3.0 ' Time Warner's common stock repurchase program has created approximately $1 billion of incremental value for its shareholders. Cost to 2/2g/g9 Acquire Value (dJ Rafios lor 1996 rel/ecr the lull�year, pro lorma ellec� ol �he 7BS acquistion and certain linanc�ng transacnons. expected to be provided by anticipated future free cash flow and financial capacity. We expect this ongoing program to continue to create incremental value for our shareholders. Leveraging Our Assets for Growth As previously envisioned, our technologically advanced, high- capacity cable architecture has enabled us to leverage our existing cable television business into new oppo�tunities to create new revenue streams and incremental value through strategic alliances. Along with our cable partners, we have formed a strategic partnership with both Microsoft and Compaq to expand our Road Runner-branded, high-speed online service. In addition, we expect our proposed joint venture with AT&T to generate incremental value from the exploitation of AT&T-branded cable telephony seroice. These businesses, together with new revenue streams from expanded digital programming options in our core cable television business, are expected to keep our cable television business strategically positioned for achieving sustainable, long-term growth. As 1999 unfolds, we expect to continue to explore strategies for leveraging our existing assets, including new media, into new growth opportunities. Creating Shareholder Value. Our foremost business objective is to create value for our shareholders. During 1998, our shareholders continued to see their value grow through 100% appreciation in Time Warner's common stock price to $62.06 per share at the end of the year. Our performance far surpassed that of the Standard & Poor's 500-stock index, which registered a gain of approximately 27% for the year. As we see it, this appreciation in value principally reflected our record financial performance in 1998 and the strategic positioning of our businesses for continued growth. With the strength and leadership positioning of our busi- nesses and our experienced management team, we believe Time Warner is in the best position ever to continue its momentum into the future. ��. ��::. �> . �-,� Richard D. Parsons President March 9, 1999 �� Richard J. Bressler ExecuGve �/ce President and Chief Financial Officer Time Warner Common Stock Price Performance vs. S&P 500 Index 12/97 12/98 Time Warner's stock price appreciated over 100% in 1998, outpacing the S&P 500's 27% gain. 7he lo�egoing discussion ol the financia! perlormance ol Time L^/arner and the Enterfainment Group, substantially all 7WE, has been pre- sented on a combined basis, which is how we evaluate and manage the businesses. This overview should be read in conjunction wilh Managemenf's Discussion and Analysis and Time Wainer's ConsoGdated Financial Statements appearing elsewheie herein. In such linancial statemen(s, Time Warner does not consolidate fhe Entertainment Group. TIME WAFNER Il.� 79)8 ANNU�'_ �EP04i 3% Financial Highlights at a Glance REVENUES _.. ._ .. 1998 Combined Revenues by Business Segment�a� $26,838 Million S Cable Networks 209�0 Publishing 16°k Entertainment 45% Cable 19a/o EBITA 1998 Combined EBITA by Business Segment�a� $4,462 Million CAPITALIZATION 1998 Combined Revenue Growth Cable Networks Publishing Entertainment Filmed Entertainment�b� t5� Music go Cable<<> Total <<� Cable Networks 26�/0 I Publishing 13% — Entertainment 24% � Cable�d� 37% 1998 Combined Capitalization (millions, as of December 31) --- ------------ - - _ .._ quivalent Shares of Common Stock: Common Stock � 232 Convertible Preferred Stock 94 StoCk Options�e� 53 Total Equivalent Shares � 3�g Total Market Equity Capitalization $ 85,584 Net Debt � 6 99g Borrowings against Future Stock Option Proceeds 895 Preferred Securities of Suosidiaries 792 Total Combined Capitalization $t04,270 11% 1998 Combined Revenues by Geographic Region $26,838 Million 5% 13% United States 80°k /o Europe 12% �� Al10ther 5% 10% >>% Asia 3% 1998 Combined EBITA Growth Cable Networks 200�0 Publishing � 50�0 Entertainment 1 1% Filmed Entertainment�b� 17% Music go�o Cable�� qo�o Total <<� 14% Combined Capitalization (millions, as of December 31) $104,270 $64,294 •. • . � : � $2007D; $20,786, $44,224 i $25,294 e Net Debt & Other �� Market Equity Capitalization (a) Percentages calculated 6e/ore intercompany eliminations. (b) Includes Fi/med En�ertarnment Warner Bros., Filmed Enfer7ainrnen��TBS and 7lre WS Network. (cJ Normalized ro exclude the elleus ol certarn cablerelated lransactions tlrar occuned in 7998 and 1992 See ManagemeM's Discuss�on and Analysis. (dl Indudes net prefax gains ol approxima�e/y $708 miNion relafed fo the sa/e nr exchange ol cable televrsion systems. (e) ReHects shares �ssued upon the e.rercise ol all stock options, net o/ shaie iepu�chases assurned to have ocwrred usmg op7ion proceeds and relafed tar benelits. Assumed share repurchases are based on Time Warner's average stock pnce lo� fhe lourth quarter o/ 1998 0/ $49.91. (0 Inc/udes net debe Series M p�e'=rred stock, prelemed secuiihes ol subsid�a��es , nd bonrn,.,ngs against lutme stock option proceeds, 38 TIMF WARNLR �'.0 I!19P ANNU,1, :1=_POHT Management's Discussion and Analysis of Results of Operations and Financial Condition DESCRIPTION OF BUSINESS Time Warner lnc. ("Time Warner° or the "Company°), together with its consolidated and unconsolidated subsidiaries, is the world's largest media and entertainment company. Time Warners principal business objective is to create and distribute branded information and entertainment copyrights throughout the world. Time Warner classifies its business interests into four fundamental areas: Cab/e Nefworks, con- sisting principally of interests in cable television program- ming; Pub/ishing, consisting principally of interests in magazine publishing, book publishing and direct marketing; Enterfainmenf consisting principally of interests in recorded music and music publishing, filmed ente�tainment, television production and television broadcasting; and Cable, consist- ing principally of interests in cable television systems. A majority of Time Warner's interests in filmed entertain- ment, television production, television broadcasting and cable television systems, and a portion of its interests in cable television programming are held through Time Warner Enter- tainment Company, L.P. ("TWE"). Time Warner owns general and limited partnership interests in TWE consisting of 74.49% of the pro rata priority capital ("Series A Capital") and residual equity capital ("Residual Capital"), and 100% of the senior priority capital ("Senior Capital") and junior priority capital ("Series B Capital"). The remaining 25.51% limited partnership interests in the Series A Capital and Residual Capital of TWE are held by a subsidiary of MediaOne Group, Inc. ("MediaOne"), formerly U S WEST, Inc. Time Warner does not consolidate TWE and certain related companies (the "Entertainment Group") for financial reporting purposes because of certain limited partnership approval rights related to TWE's interest in certain cable television systems. OVERVIEW Time Warner and the Entertainment Group demonstrated strong financial performances in 1998, as measured by the operating performance of their businesses and the improved strength of their combined financial condition, as more fully described herein. This performance was driven primarily by solid business fundamentals and a disciplined financial focus on cost management and controlling capital spending. USE OF EBITA Time Warner evaluates operating performance based on several factors, of which the primary financial measure is operating income before noncash amortization of intangible assets ("EBITA"). Consistent with management's financial focus on controlling capital spending, EBITA measures operating performance after charges for depreciation. In addition, EBITA eliminates the uneven effect across all business segments of considerable amounts of noncash amorti2ation of intangible assets recognized in business combinations accounted for by the purchase method, includ- ing the $14 billion acquisition of Warner Communications Inc. in 1989, the $6.2 billion acquisition of Turner Broadcasting System, Inc. ("TBS") in 1996 and the $2.3 bil- lion of cable acquisitions in 1996 and 1995. The exclusion of noncash amortization charges also is consistent with man- agement's belief that Time Warner's intangible assets, such as cable television and sports franchises, music catalogues and copyrights, film and television libraries and the goodwill associated with its brands, generally are increasing in value and importance to Time Warner's business objective of creat- ° ing, extending and distributing recognizable brands and copyrights throughout the world. As such, the following com- parative discussion of the results of operations of Time Warner and the Entertainment Group includes, among other factors, an analysis of changes in business segment EBITA. However, EBITA should be considered in addition to, not as a substitute for, operating income. net income and other measures of financial performance reported in accordance with generally accepted accounting principles. TRANSACTIONS AFFECTING COMPARABILITY OF RESULTS OF OPERATIONS As more fully described herein, the comparability of Time Warner's and the Entertainment Group`s operating results has been affected by certain significant transactions and nonrecurring items in each period. For 1998, these significant transactions related to Time Warner's cable business and included (i) the transfer of cable television systems (or interests therein) serving approx- imately 65�,000 subscribers that were formerly owned by subsidiaries of Time Warner to the TWE-Advance/Newhouse Partnership (`TWE-A/N"), subject to approximately $1 billion of deb1, in exchange for common and preferred partnership interests in TWE-A/N, as well as certain related transactions (collectively, the "TWE-A/N Transfers'), (ii) the transfer of TWE's and TWE-A/N's direct broadcast satellite operations and related assets to Primestar, Inc. ('Primestar"), a separate holding company (the "Primestar Roll-up Transaction"), (iii) the reorganization of Time Warner Cable's business tele- phony operalions into a separate entit,i named Time Wamer r�Nr w,�rr,=� �nc i�oe nr:au:.� ur��ok, 39 Telecom LLC (the "Time Warner Telecom Reorganization") and (iv) the formation of a joint venture to operate and expand Time Warner Cable's and MediaOne's existing high- speed online businesses (the "Road Runner Joint Venture" and collectively, the "1998 Cable Transactions"). In addition, there were a number of other significant, non- recurring items recognized in 1998 and 1997, consisting of (i) net pretax gains in the amount of approximately $108 mil- lion in 1998 and $212 million in 1997 relating to the sale or exchange of various cable television systems by Time Warner and TWE, (ii) a pretax gain of approximately $250 million in 1997 relating to TWE's sale of its interest in E! Entertainment Television, Inc. ("E! Entertainment"), (iii) a pretax gain of $200 mil- lion in 1997 relating to Time Warners disposal of its interest in Hasbro, Inc. ("Hasbro"), (iv) a charge of approximately $210 mil- lion in 1998 principally to reduce T1NE's carrying value of its interest in Primestar, (v) an increase of $234 million in Time Warner's 1998 preferred dividend requirements relating to the premium paid in connection with its redemption of Series M exchangeable preferred stock ("Series M Preferred Stock") and (vi) an extraordinary loss of $55 million in 1997 on the retirement of debt In order to meaningfully assess underiying operating trends, management believes that fhe resutts of operations for 1998 and 1997 should be analyzed after excluding the. effects of these significant nonrecurring items. As such, ihe RESULTS OF OPERATIONS 1998 vs. 1997 EBITA and operating income in 1998 and 1997 are as `ollows: Years Ended December 31, (millions) Time Warner: Publishing Music Cabie Networks-TBS Filmed Entertainment-TBS Cable"' Intersegment elimination _... . . .. Total Entertainment Group: Filmed Ente�tainment-Warner Bros. Broadcasting-The WB Network Cable Networks-HBO Cable11' Total following discussion and analysis focuses on amounts and trends adjusted to exclude the impact of these unusual items. However, unusual items may occur in any period. Accordingly, investors and other financial statement users individually should consider the types of events and transactions for which adjustments have been made. The comparability of Time Warner's 1997 and 1996 oper- ating results also was affected by certain significant transac- tions, consisting of (i) Time Warner's October 1996 acqui- sition of TBS (the "TBS Transaction"), (ii) Time Warner's use of approximately $1.55 bilfion of net proceeds from the issuance of Series M Preferred Stock in April 1996 to reduce outstand- ing indebtedness and (iii) certain other debt refinancings during the year (collectively, the "1996 Time Warner Transactions"). Accordingly, the following discussion of operat- ing results for those periods is supplemented, where appropri- ate, by pro forma financial information that gives effect to th�e 1996 Time Warner Transactions as if they had occurred at the beginning of 1996. This pro forma information is presented for informational purposes only and is not necessarily indica- tive of the operating resuits that would have occurred had the transactions actuaily occurred at the beginning of that period, nor is it necessarily indicative of future operating results. Finally, per common sha�e amounts for prior years have been restated to give effect to a two-for-one common stock split that occurred on December 15, 1998. _ EBITA Operating Income 1996 199i 1998 -------- 1997 $ 607 $ 529 $ 569 $ 487 493 467 213 166 706 573 506 374 192 200 110 113 325 427 125 150 (27) (13) (27) (13) $2,296 $2,183 $1,496 $1,271 $ 503 $ 404 $ 374 $ 281 (93) (88) (96) (88) 454 39t 454 391 1,369 1,184 992 877 $2,233 $1.891 $1,724 $1,461 (1) Includes net pretax ga�ns of approx�mzt=;: 516 rmihon -! y9g ;�� $ � p,,�;,on m 199? re'a!ed to the saie or exchan �� of certe�n cao'c •�•'e:-�s�on ,;y;tem;. (2) Includes net pretax gains of app�oxlma�,�., 5y0 :mlho� �. 199A e�d $20'J •^�Illon :•i 19�� eiated to lhe sale oi ur.;ha��qe o' ce�lain ca, e'��lo�n;�un systems- 4� 71ME WARNfR INC 19`3B ANNUAI. FFF'0�.� Time Warner had revenues of $14.582 billion and net income of $168 million ($.31 loss per common share after preferred dividend requirements) in 1998, compared to revenues of $13.294 billion, income of $301 million before an extraordinary loss on the retirement of debt ($.O1 loss per common share after preferred dividend requirements) and net income of $246 million ($.06 loss per common share after preferred dividend requirements) in 1997. Time Warner's equity in the pretax income of the Entertainment Group was $356 million in 1998, compared to $686 million in 1997. As previously described, the comparability of Time Warner's and the Entertainment Group's operating results for 1998 and 1997 has been affected by certain significant nonrecurring items•recognized in each period, consisting of gains and losses relating to the sale or exchange of cable television systems and other investment-related activity. These nonre- curring items amounted to approximately $100 million of net pretax losses in 1998, compared to approximately $660 mil- lion of net pretax gains in 1997. In addition, preferred dividend requirements for 1998 included a$234 million one-time increase relating to the premium paid in connection with Time Warner's redemption of its Series M Preferred Stock. Lastly, 1997 included a$55 miliion extraordinary loss on the retire- ment of debt. The aggregate net effect of these significant, nonrecurring items was a decrease in income per commbn share of $.25 per common share in 1998, compared to an increase of $.27 per common share in 1997. Time Warner's net income decreased to $168 miilion in 1998, compared to net income of $246 million in 1997. However, excluding the significant effect of the nonrecurring items referred to above, net income increased by $300 mil- lion to $236 million in 1998, compared to a net loss of $64 million in 1997. As discussed more fully below, this improvement principally resulted from an overall increase in Time Warner's business segment operating income, an increase in income from its equity in the pretax income of the Entertainment Group and lower interest expense associ- ated with Time Warner's deb: reduction efforts and the TWE-A/N Transfers, offset in part by higher losses from certain investments accounted for under the equity method of accounting a�d lower gains on foreign exchange con- tracts. Similarly, excluding the effect of these nonrecurring items, normalized net loss per common share was $.06 in 1998, compared to a normalized net loss per common share of $.33 in 1997. The Entertainment Group had revenues of $12256 billion and net income of $331 million in 1998, compared to rev- enues of $11.328 billion, income of $642 million before an extraordinary loss on the retirement of debt and net income of $fil9 million in 1997. Similarly, excluding the portion of the nonrecurring items referred to above that was recognized by the Entertainment Group, net income increased by $229 million to $465 million in 1998, compared to $236 million in 1997. As discussed more fully below, this improvement principaliy resulted from an overall increase in the Entertainment Group's business segment operating income (including the positive effect of the TWE-A/N Transfers), offset in part by an increase in interest expense associated with the TWE-A/N Transfers and higher losses from certain investments accounted for under the equity method of accounting. The relationship between income before inccme taxes and income tax expense of Time Warner is princ;�ally affected by the amortization of goodwill and cer.ain other financial statement expenses that are not deduc:ible for income tax purposes. Income tax expense of Tire Warner includes all income taxes rela#ed to its allocable ;hare o` partnership income and its equity in the income :ax expe�_=e of corporate subsidiaries of the Entertainment G�oup. TIME WARNER Publishing Revenues increased to $4.496 bill��n, compa�ed to $4.290 billion in 1997. EBITA increased to $c07 millior. from $529 million. Operating income increasec -� $569 n-•i.- lion from $481 million. Revenues benefited prira•�;y fror- s�g- nificant increases in magazine advertising rever_�s, as �:e l as increases in magazine circulation revenues. T�e increzse in advertising revenues was principally due to 2 s-�ong o•:e�all advertising market for most of the division's ma�azmes, pr - marily led by People, Trme, Entertainment Week... Forture and In Sfyle. The increase in circulation revenues w2s �rincipa:iv due to higher subscription and newsstand rever_=s. prima-;ly led by the same magazines. EBITA and operatin� ncome increased principally as a result of the revenue ca ns, cos� savings and one-time gains on the sale of cert2�- assets. e�f- set in part by lower results from direct marketinc ��eratiors. nr.+( wnun�� F� ir,r iUgo r.�.�.. � ui �•o�-.- 41 Music Revenues increased to $4.025 billion, compared to $3.691 billion in 1997. EBITA increased to $493 million from $467 million. Operating income increased to $213 mil- lion from $166 million. Revenues benefited from an increase in domestic and international recorded music sales principally relating to higher compact disc sales of a broad range of popular releases from new and established artists and mavie soundtracks, as well as lower returns of product At the end of December 1998, the Music division had a domestic mar- ket share of 19.8%, as measured by SoundScan. EBITA and operating income increased principally as a result of the rev- enue gains and cost savings, offset in part by lower results from direct marketing operations, higher artist costs and the absence of certain one-time gains recognized in 1997. Cable Networks-TBS Revenues increased to $3.325 bil- lion, compared to $2.900 billion in 1997. EBITA increased to $706 million from $573 million. Operating income increased to $506 million from $374 million. Revenues benefited from an increase in subscription and advertising revenues. The increase in subscription revenues principally related to the conversion of TBS Superstation from an advertiser- supported broadcast superstation to a copyright-paid, cable television service, which ailows TBS Superstation to charge cable operators for the right to carry its cable television pro- gramming. Subscription revenues also increased as a result of an increase in subscriptions, primarily at CNN, CNN International, TNT/Cartoon Europe and Turner Classic Movies, and higher rates. The increase in advertising rev- enues was principally due to a strong overall advertising market for most of the division's networks, including TNT, Cartoon Network, TNT/Cartoon Europe, CNN and CNN Headline News. EBITA and operating income increased principally as a result of the revenue gains and lower pro- gramming costs at TNT, offset in part by higher program- ming costs at CNN and losses associated with the Goodwill Games. Filmed Entertainment-TBS Revenues increased to $1.917 billion, compared to $1.531 billion in 1997. EBITA decreased to $192 million from $200 million. Operating income decreased to $1 10 million from $1 13 million. Revenues benefited from a significant increase in syndication sales resulting from the renewal by existing television station customers of second-cycle broadcasting rights for Seinfeld, as well as an increase in worldwide theatrical and home 42 11MG W,1RN[F( INC. I99y Af�'NUqL RFPORT video revenues at New Line Cinema Despite the revenue increa:,e, EBITA and operating income decreased principally as a result of film write-offs relating to disappointing results for theatrical releases of Castle Rock Entertainment in the first half of 1998. Cable Revenues decreased to $964 million, compared to $997 million in 1997. EBITA decreased to $325 million from $427 million. Operating income decreased to $125 million from $150 miUion. The Cable division's 1998 operating results were negatively affected by the aggregate net impact of the deconsolidation of certain of its operations in connection with the 1998 Cable Transactions. Excluding the effect of the 1998 Cable Transactions, revenues increased principaliy as a result of an increase in basic cable subscribers, increases in regulated cable rates and an increase in advertising revenues. Similarly excluding the effect of the 1998 Cable Transactions, EBITA and operating income increased principally as a result of the revenue gains and approximately $6 million of higher, net pre- tax gains relating 'o the sale or exchange of certain cable tele- vision systems, offset in part by higher depreciation related to capital spending. Interest and Other, Net Interest and other, net, increased to $1.180 billion in 1998, compared to $1.044 billion in 1997. Interest excense decreased to $891 million, compared to $1.049 billion. principally due to lower average debt levels associated with ��e Company's debt reduction efforts and the TWE-A/N Transfers. There was other expense, net, of $289 million in 1998 compared to other income, net of $5 mil- lion in 1997, primarily due to lower investment-related income, as well as lower cains on foreign exchange contracts and higher losses asscciated with the Company's asset securitiza- tion program. The s;gnificant decrease in investment-related income principall� resulted from the absence of a$200 mil- lion pretax gain recognized in i 997 in connection with the disposal of Time \':arner's interest in Hasbro and higher losses in 1998 from certain investments accounted for under the equity method of accounting. ENTERTAINMENT GROUP Filmed Entertainment-Warner Bros. Revenues increased to $6.061 billion. compared to $5.472 billion in 1997. EBITA increased to $503 million from $404 million. Operating income increaseo to $374 million from $281 million. Revenues benefited from a significant increase in licensing fees from television production and distribution operations, principally relating to the initial off-network domestic syndi- cation availability of Friends and the initial off-network basic cable availability of ER, as well as an increase in revenues from consumer products licensing operations. EBITA and operating income benefited principally from the revenue gains and cost savings, offset in part by lower international syndication sales of library product and lower results from theatrical releases. In addition, EBITA and operating income for each period included certain one-time gains on the sale of assets that were comparable in amount and therefore, did not have any significant effect on operating trends. Broadcasting-The WB Network Revenues increased to $260 million, compared to $136 million in 1997. EBITA decreased to a loss of $93 million from a loss of $88 mil- lion. Operating losses increased to $96 million from $88 million. Revenues increased as a result of higher advertising sales relating to improved television ratings and the addition of a fourth night of prime-time program- ming in January 1998 and a fifth night in September 1998. Despite the revenue increase, operating losses increased because of a lower allocation of losses to a minor- ity partner in the network. However, excluding this minority interest effect, operating losses improved principally as a result of the revenue gains, which outweighed higher programming costs associated with the expanded programming schedule. Cable Networks-HBO Revenues increased to $2.052 bil- lion, compared to $1.923 billion in 1997. EBITA and operat- ing income increased to $454 million from $391 million. Revenues benefited primarily from an increase in subscriptions to 34.6 million from 33.6 million at the end of 1997. EBITA and operating income improved principally as a result of the revenue gains and, to a lesser extent, cost savings and higher income from Comedy Central, a 50%-owned equity investee. Cable Revenues increased to $4.378 billion, compared to $4.243 billion in 1997. EBITA increased to $1.369 billion from $1.184 billion. Operating income increased to $992 million from $877 million. The Cable division's 1998 operating results were positively affected by the aggregate net impact of the 1998 Cable Transactions. Excluding the effect of the 1998 Cable Transactions, revenues increased principally as a result of an increase in basic cable subscribers, increases in regu- lated cable rates and an increase in advertising revenues. Similarly excluding the effect of the 1998 Cable Transactions, EBITA and operating income increased principally as a result of the revenue gains, offset in pa�t by higher depreciation related to capital spending and approximately $110 miliion of lower, net pretax gains relating to the sale or exchange of certain cable television systems. As of December 31, 1998, including the cable operations of TWE-A/N and TWI Cable Inc. ("TWI Cable"), there were. 12.6 miilion subscribers under the management of TWE's Cable division, as compared to 12.0 million subscribers at the end of 1997. The number of subscribers at the end of 1997 exciudes all direct broadcast satellite subscribers that were transferred to Primestar in 1998 in connection with the Primestar Roll-up Transaction. Interest and Other, Net Interest and other, net, increased to $965 million in 1998, compared to $357 million in 1997. Interest expense increased to $566 million, compared to $494 million in 1997, principally due to higher average debt levels associated with the TWE-A/N Transfers. There was other expense, net; of $399 million in 1998, compared to other income, net, of $137 million in 1997, primarily due to lower investment-related income, as well as higher losses associated with TWE's asset securitization program. The significant decrease in investment-related income principally resulted from the absence of an approximate $250 million pretax gain recognized in 1997 in connection with the sale of an interest in E! Entertainment, the inclusion of an approx- imate $210 million charge recorded in 1998 principally to reduce the carrying value of an interest in Primestar and higher losses in 1998 from certain investments accounted for under the equity method of accounting. TIMC WARNERINC I�yNANNUAI RfPORT 43 1997 vs. 1996 EBITA and operating income in 1997 and 199fi are as follows: Years Ended December 31, (millions) EBITA Historical Pro Forma 1997 1996 Time Warner: Publishing $ 529 $ 464 Music 467 653 Cable Networks TBS 573 472 Filmed Entertainment-TBS 200 (� 16) Cable"' 427 353 Intersegment elimination (13) (10) _ . ...... ............_.... ........ ... ..._............. _.... . _ _ .. .... _ . ...... . . . _.. . _. ...... . Total $2,183 $1,816 Historical 1996 $ 464 653 142 30 353 5 $1,647 Operating Income Historical Pro Forma Historical 1997 1996 t996 $ 481 166 374 113 150 (13) $1,271 $ 418 361 297 (202) 75 (10) $ 939 $ 418 361 99 8 75 5 .. $ 966 Entertainment Group: Filmed Entertainment-Warner Bros. $ 404 $ 379 $ 379 $ 281 $ 25a $3 25a Broadcasting-The WB Network (88) (gg) (gg) (gg) (gg) (gg) Cable Networks-HBO 391 328 328 391 328 328 Cable"' 1,184 917 917 877 606 606 _. ... ...... .. . . ...._.... .. .. ..... . . .. ..... ..... _ ... . . _......... Total $1,891 $1,526 $1,526 $1,461 $1,090 $1,090 (1) Includes net pretax gains in 1997 of appioximately $12 million for Time Warner and $200 million for the Entertainment Group related to the sale o� ezchange of certain cable tetevision systems. Time Warner had revenues of $13294 biliion, income of $301 million before an extraordinary loss on the retirement of debt ($.01 loss per common share after preferred dividend requirements) and net income of $246 million ($.06 loss per common share after preferred dividend requirements) in 1997, compared to revenues of $10.064 billion, a loss of $156 million before an extraordinary loss on the retirement of debt ($.48 per common share after preferred dividend requirements) and a net loss of $191 million ($.52 per com- mon share after preferred dividend requirements) in 1996. Time Warner's equity in the pretax income of the Entertain- ment Group was $686 million in 1997, compared to $290 million in 1996. Time Warner's historical results of operations include the operating results of TBS from October 10, 1996. On a pro forma basis, giving effect to the 1996 Time Warner Transactions as if each of such transactions had occurred at the beginning of 1996, Time Warner would have reported for the year ended December 31, 1996, revenues of $12.799 billion, depreciation expense of $368 million, EBITA of $1.816 billion, operating income of $939 million, equity in the pretax income of the 44 TIME W�RN[F2 INC. 19�8 �NNUAI. REPDRI Entertainment Group of $290 million, a loss before extraor- dinary item of $282 million ($.52 per common share) and a net loss of $317 million ($.55 per common share). No pro forma financial information has been presented for Time Warner for the year ended December 31, 1997 because the 1996 Time Warner Transactions are already reflected in the historical financial statements of Time Warner. As previously described, the comparaoility of Time Warner's and the Entertainment Group's historical operating results for 1997 and pro forma results for 1996 has been affected further by certain significant nonrecurring items recognized in 1997, consisting of net pretax gains relating to the sale or exchange of cable television systems and other investment-related activity. These nonrecurring items amounted to approximately $660 million of net pretax gains in 1997. In addition, net income (loss) in each period included extraordinary losses on the retirement of debt of $55 million in 1997 and $35 million in 1996. The aggregate net effect of these significant. nonrecurring items was an increase in income per common share of $.27 in 1997, com- pared to a decrease of $.03 per common share in 1996. Time Warner's operating results improved from a pro forma net loss of $317 million in 1996 to net income of $246 mil- lion in 1997. Excluding the significant effect of the nonrecur- ring items referred to above, Time Warner's net loss improved by $218 million to a net foss of $64 million in 1997, com- pared to a net loss of $282 million on a pro forma basis in 1996. As discussed more fully below, this improvement princi- pally resulted from an overall increase in Time Warner's EBITA and operating income and an increase in income from its equity in the pretax income of the Entertainment Group. Similarly, excluding the effect of these nonrecurring items, normalized net loss per common share was $.33 in 1997, compared to a normalized net loss per common share of $.52 on a pro forma basis in 1996. On a historical basis, these underlying operating trends were mitigated by an overall increase in interest expense principally relating to the assumption of approximately $2.8 bil- lion of debt in the TBS Transaction, and an increase in noncash amortization of intangible assets, also relating to the TBS Transaction. On a historical basis, after preferred dividend requirements that increased by $62 million due to the April 1996 issuance of Series M Preferred Stock, Time Watner's net loss applicable to common shares improved to $73 million for. the year ended December 31, 1997, compared to $448 mil- lion for the year ended December 31, 1996. This improve- ment, as well as the dilutive effect from issuing 359.6 million equivalent shares of common stock in connec#ion with the TBS Transaction, resulted in a net loss per common share of $.06 for the year ended December 31, 1997, compared to a$.52 net loss per common share for the year ended December 31, 1996. On a historical basis, the Entertainment Group had rev- enues of $1 1.328 billion, income of $642 million before an extraordinary loss on the retirement of debt and net income of $619 million in 1997, compared to revenues of $10.861 billion and net income of $220 million in 1996. Similarly, excluding the portion of the nonrecurring items referred to above that was recognized by the Entertainment Group, net income increased by $16 million to $236 mil- lion in 1997, compared to $220 million in 1996. As dis- cussed more fully below, this improvement principally resulted from an overall increase in EBITA and operating income generated by the Entertainment Group's business segments, offset in part by an increase in minority interest expense related to TWE-A/N. The re'�tionship between income before income taxes and income tax expense of Time Warner is principally affected by the amortization of goodwill and certain other financial statement expenses that are not deductible for income tax purposes. Income tax expense of Time Warner includes all income taxes related to its allocable share of partnership income and its equity in the income tax expense of corporate subsidiaries of the Entertainment Group. TIME WARNER Publishing Revenues increased to $4.290 billion, compared to $4.1 17 billion in 1996. EBITA increased to $529 million from $464 million. Operating income increased to $481 million from $418 million. Excluding the effect of operations that were either recently sold or acquired, revenues benefited from a significant increase in magazine advertising revenues, as well as increases in circu- lation and direct marketing revenues. Contributing to the revenue gains were increases achieved by Peop/e, Sports lllusfrated, Time, Entertainmenf Weekly, In Sfyle and direct marketer Book-of-the-Month Club. EB.ITA and operating income increased principally as a result of the revenue gains and, to a lesser extent, continued cost savings. Music Revenues decreased to $3.691 billion, compared to $3.949 billion in 1996. EBITA decreased to $467 million from $653 million. Operating income decreased to $166 mil- lion from $361 million. Despite the Music division having a domestic market share for the year of 20% as measured by SoundScan, the decline in revenues principally related to softness in the overexpanded U.S. retail marketplace, artist delays affecting the timing of releases of new product and a decline in international recorded music sales. EBITA and operating income decreased principally as a result of the decline in revenues and lower results from direct marketing activities, offset in part by certain one-time gains. Cable Networks-TBS Cable Networks results reflect the acquisition of TBS effective in October 1996. Such operat- ing results are not comparable to the prior year and, accord- ingly, are discussed on a pro forma basis. Revenues increased to $2.900 billion, compared to $2.477 billion on a pro forma basis in 1996. EBITA increased to $573 million from $472 million. Operating income increased to $374 million from $297 million. . ., ,. . . . ' 71A'!- Y,'ARI�f R It:C. 1�{lfl ANNIIAI.�Rf 1'C)RT.4 �j', . � Revenues benefited from increases in adve�tising and subscription revenues. Advertising revenues increased d��: to a strong overall advertising market for the division's major branded networks, including TNT, TBS Superstation, CNN and Cartoon Neiwork. Subscription revenues increased as a result of higher rates and an increase in subscriptions, primarily at TNT, CNN, Cartoon Network and Turner Classic Movies. EBITA and operating income increased principally as a result of the revenue gains, offset in part by start-up costs for new networks, including the sports news network CNN/SI and the Spanish-language news neiwork CNN en Espanol. Filmed Entertainment-TBS Filmed Entertainment results reflect the acquisition of TBS effective in October 1996. Such operating results are not comparable to the prior year and, accordingly, are discussed on a pro forma basis. Revenues increased to $1.531 billion, compared to $1.458 billion on a pro forma basis in 1996. EBITA increased to $200 million from a loss of $116 million. Operating income increased to $1 13 million from a loss of $202 miilion. Revenues benefited from increases in worldwide theatrical, home video and television distribution revenues. EBITA and operating income increased principally as a result of the revenue gains, merger-related cost savings and the absence of approximately $200 million of write-offs recorded in 1996 that related to disappointing results for theatrical releases. Cable Revenues increased to $997 million, compared to $909 miliion in 1996. EBITA increased to $427 million from $353 million. Operating income increased to $150 million from $75 million. Revenues benefited from an increase in basic cable subscribers, increases in regulated cable rates and an increase in advertising and pay-per-view revenues. EBITA and operating income increased principally as a result of the revenue gains, as well as gains of approximately $12 million recognized in 1997 in connection with the sale of certain investments. Interest and Other, Net Interest and other, net, decreased to $1.044 billion in 1997, compared to $1.174 biliion in 1996. Interest expense increased to $1.049 billion, compared to $968 million, principally due to the assumption of approx�- mately $2.8 billion of debt in the TBS Transaction. There was other income, net, of $5 million in 1997 compared to other expense, net, of $206 million in 1996, principally because of the recognition of a$200 million pretax gain in 1997 in con- nection with the redemption of certain mandatorily redeemable CB 11ME WARNER INC 199H ANNUAL REf'ORT preferred securities and the related disposal of Time Warner's interest in Hasbro and lower losses from the reduction in car- rying value of certain investments, offset in part by costs asso- ciated with the Company's asset securitization program. ENTERTAINMENT GROUP Filmed Entertainment-Warner Bros. Revenues decreased to $5.472 billion, compared to $5.648 billion in 1996. EBITA increased to $404 million from $379 million. Operating income increased to $281 million from $254 million. Revenues decreased principally as a result of lower world- wide theatrical and home video revenues, offseY in part by increases in worldwide television distribution revenues. EBITA and operating income increased principaily as a result of high-margin sales of library product that contributed to the strong performance of worldwide television distribution operations, cost savings and certain one-time gains, offset in part by higher depreciation principally relating to the expan- sion of theme parks and consumer products operations. Broadcasting-The WB Network Revenues increased to $136 million, compared to $87 million in 1996. EBITA and operating losses improved to a loss of $88 million from a loss of $98 million. The increase in revenues primarily resulted from the expansion of programming in September 1996 to three nights of prime-time scheduling and the expansion of Krds' WB!, the network's animated program- ming lineup on Saturday mornings and weekdays. The 1997 operating loss improved principally as a result of the revenue gains and the effect of an increase in a limited partner's interest in the network that occurred in eariy 1997. Cable Networks-HBO Revenues increased to $1.923 bil- lion, compared to $1.763 biliion in 1996. EBITA and operat- ing income increased to $391 million from $328 million. Revenues benefited primarily from an increase in subscrip- tions to 33.6 million from 32.4 million at the end of 1996. EBITA and operating income improved principally as a result of the revenue gains and, to a lesser extent, cost savings. Cable Revenues increased to $4.243 billion, compared to $3.851 billion in 1996. EBITA increased to $1.184 billion from $917 million. Operating income increased to $877 mil- lion from $606 million. Revenues benefited from an increase in basic cable and Primestar-related, direct broadcast satel- lite subscribers, increases in regulated cable rates and an increase in advertising and pay-per-view revenues. EBITA and operating income increased principally as a result of the revenue gains, as well as net gains of approximately $200 million recognized in 1997 in connection with the sale or exchange of certain cable systems. The increases in EBITA and operating income were partially offset by higher depreciation related to capitai spending. As of December 31, 1997, including Primestar-related, direct broadcast satellite subscribers and the cable opera- tions of TWE-A/N and TWI Cable, there were 12.6 million subscribers under the management of TWE's Cable division, as compared to 12.3 million subscribers at the end of 1996. interest and Other, Net Interest and other, net, decreased to $357 million in 1997, compared to $524 million in 1996. Interest expense increased to $494 million, com- pared to $478 million in 1996. There was other income, net, of $137 million in 1997, compared to other expense, net, of $46 million in 1996, principally due to higher gains on asset sales, including an approximate $250 million pretax gain on tfie sale of an interest in E! Entertainment recog- nized in 1997. This income was offset in part by higher losses from reductions in the carrying value of certain invest- ments and the dividend requirements on preferred•stock of a subsidiary issued in February 1997. FINANCIAL CONDITION AND LIQUIDITY DECEMBER 31, 1998 TIME WARNER 1998 Financial Condition At December 31, 1998, Time Warner had $1,0.9 billion of debt, $442 million of available cash and equivalents (net debt of $10.5 billion), $895 mil- lion of borrowings against future stock option proceeds, $575 million of mandatorily redeemable preferred securities of a subsidiary and $8.9 billion of shareholders' equity, com- pared to $11.8 billion of debt, $645 million of available cash and equivalents (net debt of $1 1.2 billion), $533 million of borrowings against future stock option proceeds, $575 million of mandatorily redeemable preferred securities of a subsidiary, $1.9 billion of Series M Preferred Stock and $9.4 billion of shareholders' equity at December 31, 1997. Financing Activities During 19g$, Time Warner continued its debt reduction efforts. Debt reduction of approximately $3 billion was partially offset by a$2. t billion increase in debt in order to fund the 1998 redemption of Time Warner's Series M Preferred Stock This debt reduction was achieved principally by using cash provided by operations, proceeds from certain asset sales, cash distributions from TWE and the noncash transfer of approximately $1 billion of debt to TWE-A/N as part of the TWE-A/N Transfers. In addition, during 1998, holders of Time Warner's $1.15 bil- lion of zero-coupon convertible notes due 2013 (the "Zero- Coupon Convertible Notes") converted their notes into an aggregate 37.4 million shares of Time Warner common stock. In order to partially offset the dilution resulting from this conver- sion, Time Warner incurred a corresponding $1.15 billion of debt and used the proceeds to repurchase common stock. Stock Option Proceeds Credit Facility In early 1998, Time Warner entered into a new five-year, $1.3 billion revolving credit facility (the "Stock Option Proceeds Credit Facility"), which replaced its previously existing facility. Borrowings under the Stock Option Proceeds Credit Facility are principally used to fund stock repurchases and approximately $12 million of fu:��e preferred dividend requirements on Time Warner's convertible preferred stock. At December 31, 1998 and 1997, Time Warner had outstanding borrowings against future stock option pro- ceeds of $895 million and $533 million, respectively. Because borrowings under the Stock Option Proceeds Credit Facility are expected to be principally repaid by Time Warner from the cash proceeds related to the exercise of employee stock options, Time Warner's principal credit ratin� agencies have concluded that such borrowings and relateo financing costs are credit neutral and are excludable from debt and interest expense, respectively, for their purposes in evaluating Time Warner's leverage and coverage ratios. In addition, because Time Warner has committed to use the Stock Option Proceeds Credit Facility to fund preferred dividend requirements on certain series of its convertible preferred stock, and has entered into certain escro�v arrange- ments, Time Warner's principal credit rating agencies similar . exclude such preferred dividend requirements for purposes of evaluating Time Warner's coverage ratio. See Note 8 to the accompanying consolidated financial statements for a summary of the principal terms of the Stock Option Proceeds Credit Facility. Redemption of Series M Preferred Stock In December 1998, Time Warner redeemed all of its outstanding shares o- 10%% Series M Preferred Stock. The aggregate redemptior cost of approximately $2.1 billion was funded with proceeds ,i:-i �•,,.i:in i: i;:r ia��r� n::.v, :.� �-i i��>;:� a7 from the issuance of lower-cost debt (the "1998 Series M Refinancing"). Because the we�ghted-average interest rate of the debt is approximately 375 basis points lower than the divi- dend rate of the Series M Preferred Stock and the interest on the debt is tax deductible (whereas dividends are not), Time Warner expects to realize approximately $100 to $125 million of annual cash savings as a result of this redemption. Preferred Stock Conversions During 1998 and January 1999, Time Warner issued approximately 66 million shares of common stock in connection with the conversion of 15.8 mil- lion shares of convertible preferred stock. These conversions are expected to result in appreximately $60 million of cash dividend savings in the aggregate for Time Warner through the end of 1999. Common Stock Repurchase Program During 1998, Time Warner acquired 59.9 million shares of its common stock at an aggregate cost of $2.24 billion under its existing common stock repurchase program, thereby increasing the cumulative shares purchased to approximately 95.1 million shares at an aggregate cost of $3.04 billion. Except for repurchases of common stock using borrowings in 1998 that offset $1.15 bil- lion of debt reduction associated with the conversion of the Zero-Coupon Convertible Notes into common stock, these repurchases were funded with stock option exercise proceeds and borrowings under Time Warner's Stock Option Proceeds Credit Facility. In January 1999, Time Warner's Board of Directors authorized a new common stock repurchase program that allows the Company to repurchase, from time to time, up to $5 billion of common stock. This program is expected to be completed over a three-year period. However, actual repur- chases in any period will be subject to market conditions. Along with stock option exercise proceeds and borrowings under the Stock Option Proceeds Credit Facility, additional funding for this program is expected to be provided by antici- pated future free cash flow and financial capacity. Credit Statistics The combination of EBITA growth, con- trolled capital spending and debt reduction has resulted in improvements in Time Wamer's financial condition and overall financial flexibility, as reflected in its strengthening financial ratios. These ratios, consisting of commonly used financial measures such as leverage and coverage ratios, are used by credit rating agencies and other credit analysts to measure the ability of a company to repay debt (leverage) and to pay interest and preferred dividends (coverage). As a result of the a8 n,,:_ weu:r, n,:,. .:, ;,nn��ci iau-c; continuing improvements in Time Warner's financial perfor- mance, each of Standard & Poor's and Moody's, Time Warner's principal credit rating agencies, upgraded Time Warner in 1998 to an improved investment-grade credit rating. The leverage and coverage ratios are set forth below for each of Time Warner and Time Warner and the Entertain- ment Group combined. Certain rating agencies and other credit analysts place more emphasis on the combined ratios, while others place more emphasis on the Time Warner stand-alone ratios. It should be understood, however, that the assets of the Entertainment Group are not freely available to fund the cash needs of Time Warner. The leverage ratio represents the ratio of total debt, less available cash and equivalents, to total business segment operating income before depreciation and amortization, less corporate expenses ("Adjusted EBITDA"). The coverage ratio repre- sents the ratio of Adjusted EBITDA to totai interest expense and/or preferred dividends. Time Warner and Entertainment Group combined: Leverage ratio Interest coverage ratio�b� Interest and preferred dividends coverage ratio�b>�� Time Warner: Leverage ratio Interest coverage ratio�b> Interest and preferred dividends coverage ratio�b><<� Historical Pro Forma 1998 1997 1996�a� 3.Ox 3.2x 4.Ox 3.5x 3.3x 2.8x 4.1 x 4.5x 3.1 x 2.5x 2.3x 1.9x 4.1 x 2.9x 2.3x 5.9x 2.Ox 1.5x ia) P�, io�r-a a':o; for � 955 y �e effect to ;he 1996 Time Wamer Transadions as �( ;ne; hac eccurred a! the bzginning of 1996. Historical ratios for 1996 are not me?n -y-ful and have r.ot been presented because they refled the operating res��its oi -35 for onlq a portion of the year in comparison to yearend net deb, I?ve g. (b) E�cludes -lerest pa�d to TWE in connection with borrowings under Time Waner; 5a00 mil6on credi; agreement with TWE and excludes i�terest on borro.��nc; ,:nder the S,ec:c OpLon Proceeds Credit Facil�ty (c) InG�.:des c. cends related !e certain preferred securi;ies of subsidiaries. E..dudes c•?`erred drvidends that Time Wam=r has funded with borrowings wid"r :c, j'.xk Opbons ?�oceeds Credd Facdity. Cash Flows During 1998, Time Warner's cash provided by operations amounted to $1.845 billion and reflected $2.296 bil- lion of EBITA from its Publishing, Music, Cable Networks TBS, Filmed Entertainment TBS and Cable businesses, $378 million of noncash depreciation expense, $17 million of proceeds from Time Warners asset securitization program and $698 million of distributions from TWE (excluding $455 million representing the return of a portion of the Time Warner General Partners' Senior Capital interest that has been classified as a source of cash from investing activities), less $812 million of interest payments, $209 million of income taxes, $86 million of corporate expenses and $437 million related to an increase in other working capital requirements, balance sheet accounts and noncash items. Cash provided by operations of $1.408 billion in 1997 reflected $2.183 billion of business segment EBITA, $382 million of noncash depreciation expense, $108 million of proceeds from Time Warners asset securitization program and $479 million of distributions from TWE (similarly excluding $455 million repre- senting the return of a po�tion of the Time Warner General Partners' Senior Capital interest that has been classified as a source of cash from investing activities), less $929 million of interest payments, $253 million of income taxes, $81 million of corporate expenses and $481 million related to an increase . in other working capital requirements, balance sheet accounts and noncash items. Cash provided by investing activities was $353 million in 1998, compared to cash used by investing activities of $45 million in 1997, principally as a result of lower capital � expenditures and an increase in investment proceeds relat- ing to Time Warner's debt reduction efforts, partially offset by an increase in cash used for investments and acquisitions. Cash used for investments and acquisitions in 1998 was offset in part by the effect of consolidating approximately $200 million of cash of Paragon Communications ("Paragon") in connection with the TWE-A/N Transfers. Capital expenditures decreased to $512 million in 1998, compared to $574 million in 1997. Cash used by financing activities was $2.401 biilion in 1998, compared to $1.232 billion in 1997. Dunng 1998, Time Warner issued approximately $2.1 billion of debt and used the proceeds therefrom to redeem its Series M Pre- ferred Stock. Time Warner also had additional borrowings in 1998 that offset the noncash reduction of $1.15 billion of debt relating to the conversion of the Zero-Coupon Convertible Notes into common stock. Time Warner used the proceeds from these borrowings, together with most of the combined $740 million of proceeds received from the exercise of employee stock options and $362 million of net borrowings against future stock option proceeds, to repur- chase approximately 59.9 million shares of Time Warner common stock at an aggregate cost of $224 billion. In addition, Time Warner paid $524 million of dividends in 1998, reflecting its election in 1998 to pay dividends on its Series M Preferred Stock in cash rather than in-kind. Cash used by financing activities in 1997 principally resulted from approximately $1 billion of debt reduction, the repur- chase of approximately 12.4 million shares of Time Warner common stock at an aggregate cost of $344 million and the payment of $338 million of dividends, offset in part by pro- ceeds received from the exercise of employee stock options. The assets and cash flows of TWE are restricted by certain borrowing and partnership agreements and are unavailable to Time Warner except through the payment of certain fees, reim- bursements, cash distributions and loans, which are subject to limitations. Under its bank credit agreement, TWE is permitteo to incur additional indebtedness to make loans, advances, distributions and other cash payments to Time Warner, subjec: to its individual compliance with the cash flow coverage and leverage ratio covenants contained therein. Management believes that Time Warner's operating cash flow, cash and equivalents and additional borrowing capacity are sufficient to fund its capital and liquidity needs for the foreseeable future without distributions and loans from TWE above those permitted by existing agreements. ENTERTAINMENT GROUP 1998 Financial Condition At December 31, 1998. the Entertainment Group had $6.6 billion of debt, $87 million of cash and equivalents (net debt of $6.5 billion), $21'7 million of preferred stock of a subsidiary, $603 million of Time Warner General Partners' Senior Capital and $5.2 billion of partners' capital, compared to $6.0 billion of debt, $322 million of cash and equivalents (ret debt of $5.7 billion), $233 million of pre- rerred stock of 2 subsidiary, $1.1 billion of Time Warner Genera! Partners' Senior Capital and $6.4 billion of partners' capital at December 31, 1997. Net debt of the Entertainment Group increased in 1998 pr�ncipally as a resul; of the TWE-A/N Transfers and increased borrowings to fund cash distributions �:,� ,,,.,;�:� � ��,. �,��„ ��,�,�.,:.. ..,,c� as It paid to Time Warner, partially offset by approximately $650 mil- lion of debt reduction associated with the formation of a cable television joint venture in Texas (the "Texas Cable Joint Venture") with TCI Communications, Inc. ('TCI"), a subsidiary of Tele- Communications, Inc. Credit Statistics Ente�tainment Group leverage and coverage ratios for 1998, 1997 and 1996 were as follows: Historical 1998 1997 1996 Leverage ratio 2.1 x 2.Ox 2.4x Interest coverage ratio�a� 5.3x 5.4x 4.8x (a) Includes dividends related to the preferred stock of a subsidiary. Cash Flows In 1998, the Entertainment Group's cash pro- vided by operations amounted to $2.288 billion and reflected $2.233 biliion of EBITA from the Filmed Entertainment-Warner Bros., Broadcasting-The WB Network, Cable Networks-HBO and Cable businesses, $927 million of noncash depreciation expense and $166 million from TWE's asset securitization pro- gram, less $537 million of interest payments, $91 million of income taxes, $72 million of corporate expenses and $338 mil- lion related to an increase in working capital requirements, other balance sheet accounts and noncash items. Cash provided by operations of $1.799 biliion in 1997 reflected $1.891 billion of business segment EBITA, $956 million of noncash depreciation expense and $300 million from NVE's asset securitization pro- gram, less $493 million of interest payments, $95 million of income taxes, $72 million of corporate expenses and $688 mil- lion related to an increase in working capital requirements, other balance sheet accounts and noncash items. Cash used by investing activities was $745 million in 1998, compared to $1.217 billion in 1997, principally as a result of a$726 million increase in investment proceeds, offset in part by a reduction of cash flows from investments and acquisitions related to the deconsolidation of approximately $200 million of Paragon's cash in conrection with the TWE-A/N Transfers. Investment proceeds increased principally due to TWE's debt reduction efforts, including proceeds from the sale of TWE's remaining interest in Six Flags Entertainment Corporation and the receipt of approximately $650 million of proceeds upon the SO iIMF WARN[R In'C Iy90 ANNUAL REPOR7 formation of the Texas Cable Joint Venture. Capital expendi- tures were $1.603 billic�i in 1998, compared to $1.565 bil- lion in 1997. Cash used by financing activities was $1.778 billion in 1998, compared to $476 million in 1997. The use of cash in 1998 principally reflected $1.153 billion of distributions paid to Time Warner and the use of investment proceeds to reduce debt in connection with TWE's debt reduction efforts. The use of cash in 1997 principally reflected $934 million of distributions paid to Time Warner, offset in part by $243 mil- lion of aggregate net proceeds from the issuance of pre- ferred stock of a subsidiary and an increase in borrowings used to fund cash distrbutions to Time Warner. Management believes that the Ente�tainment Group's operating cash flow, cash and equivalents and additional bor- rowing capacity are sufficient to fund its capital and liquidity needs for the foreseeable future. Cable Capital Spending Time Warner Cable has been engaged in a plan to upgrade the technological capability and reliability of its cable television systems and develop new services, which it believes will keep the business positioned for sustained, long-term growth. Capital spending by Time Warner Cable, including the cable operations of both Time Warner and TWE, amounted to $1.676 billion in 1998, compared to $1.683 billion in 1997. Cable capital spending for 1999 is budgeted to be approxi- mately $1.5 billion and is expected to continue to be funded by cable operating cash flow. In exchange for certain flexibility in establishing cable rate pricing structures for regulated seroices and consistent with Time Warner Cable's long-term strategic plan, Time Warner Cable agreed with the Federal Communi- cations Commission (the "FCC") in 1996 to invest a total of $4 billion in capital costs in connec±ion with the upgrade of its cable infrastructure. The agreement with the FCC covers all of the cable operations of Time Warner Cable, including the owned or managed cable television systems of Time Warner, TWE and TWE-A/N. As of December 31, 1998, Time Warner Cable had approximately $1 billion remaining under this commitment. Management expects to satisfy this commitment by December 31, 2000 when Time Wamer Cable's techno- logical upgrade of its cable television systems is scheduled to be substantially completed. CABLE STRATEGY In addition to using cable operating cash flow to finance the level of capital spending necessary to upgrade the technolog- ical capability of cable television systems and develop new services, Time Warner, NVE and NVE-A/N have completed or announced a series of transactions over the past year related to the cable television business and related ancillary businesses. These transactions consist of the TWE-A/N Transfers, the Primestar Roll-up Transaction, the Time Warner Telecom Reorganization, the formation of the Road Runner Joint Venture, the formation of the Texas Cable Joint Venture and other TCI-related cable transactions and the anticipated formation with AT&T Corp. ("AT&T") of a cable telephony joint venture (the AT&T Cable Telephony Joint Venture"). All of these transactions have reduced, or wili reduce, either existing debt and/or Time Warner's and 7WE's share of future funding requirements for these businesses. In addi- tion, the formation of the Road Runner Joint Venture and, ultimately, the AT&T Cable Telephony Joint Venture, when completed, will enable Time Warner Cable to leverage its technologically advanced, high-capacity cable architecture into new opportunities to create incremental value through the development and exploitation of new services with strategic partners, such as AT&T, Microsoft Corp. and Compaq Computer Corp. The proposed AT&T Cable Telephony Joint Venture is discussed more fully below and the other transactions are described in Note 2 to the accompanying consolidated financial statements. AT&T Cable Telephony Joint Venture In February 1999, Time Warner, TWE and AT&T announced their intention to torm a strategic joint venture. This joint venture will offer AT&T-branded cable telephony service to residential and small business customers over Time Warner Cable's televi- sion systems for up to a twenty-year period. This transaction effectively will allow Time Warner Cable to leverage its exist- ing cable infrastructure into a new growth opportunity in a non-core business, without the need for any incremental capital investment. Under the preliminary terms announced by the parties, the joint venture will be owned 22.5% by Time Warner Cable and 77.5% by AT&T. AT&T will be responsible for funding all of the joint venture's negative cash flow and Time Warner Cable's equity interest in the joint venture will not be diluted as a result of AT&Ts funding obligations. Because AT&T i� expected to have significant funding obligations through at least the first three years of the joint venture's operations when capital will be deployed and services first rolled-out, Time Warner Cable expects to benefit from the additional value created from its "carried" interest In addition to its equity interest, Time Warner Cable is expected to receive the following payments from the joint venture: (i) Approximately $300 million of initial access fees, based on a rate of $15 per home passed that is payable in two annuai installments once a particular service area ha� been upgraded and powered for cable telephony service. Time Warner Cable is expected to receive additionat access fees in the future as its cable television systems continue to pass new homes. (ii) Recurring monthly subscriber fees in the initial amount of $1.50 per telephony subscriber, to be adjusted periodically to up to $6.00 per telephony subscriber in the sixth year of providing cable telephony service to any particular area. In addition, the joint venture is expected to guarantee certain minimum penetration levels to Time Warner Cable. ranging from 5% in. the second year of providing cable telephony service to any particular area to up to 25% in the sixth year and thereafter. (iii) Additional monthly subscriber fees equal to 15% of the excess, if any, of monthly average cable telephony revenues in a particular service area over $100, after the fifth year of providing cable telephony service to any particular area. Further, management believes that the oppor,unity for consumers to select one provider of AT&T-brandeo. "all- distance" wireline and wireless communication sen-ices will contribute to increased cable television penetrai;on and the continuing growth in Time Warner Cable's revenues from the detivery of cable television services. This transaction is expected to close in the second half of 1999, subject to the execution of definitive agreements by the parties and customary closing conditions, including the approval of Advance/Newhouse and MediaOne and all nec- essary governmental and regulatory approvals. There can be no assurance that such agreements will be completed or that such approvals will be obtained. rir„i wnr,Nr-i; iN�' i�s�a.:..._._, ,[ro:i 51 OFF-BALANCE SHEET ASSETS As discussed below, Time Warner believes that the value of certain off-balance sheet assets should be considered, along with other factors discussed elsewhere herein, in evaluating the Company's financial condition and prospects for future results of operations, including its ability to fund its capital and liquidity needs. Intangible Assets As a creator and distributor of branded information and entertainment copyrights, Time Warner and the Entertainment Group have a significant amount of inter- nally generated intangible assets whose value is not fuily reflected in their respective consolidated balance sheets. Such intangible assets extend across Time Warner's principal business interests, but are best exemplified by Time Warner's collection of copyrighted music product, its libraries of copy- righted film and television product and the creation or exten- sion of brands. Generally accepted accounting principles do not recognize the value of such assets, except at the time they may be acquired in a business combination accounted for by the purchase method of accounting. Because Time Warner normally owns the copyrights to such creative material, it continually generates revenue through the sale of such products across different media and in new and existing markets. The value of film and television- related copyrigHted product and trademarks is continually realized by the licensing of films and television series to sec- ondary markets and the licensing of trademarks, such a5 the Looney Tunes characters and Bafman, to the retail industry and other markets. In addition, technological advances, such as the introduction of the compact disc and home v�deocas- sette in the 1980's and, potentially, the current exploitation ot the digital video disc, have historically generated signifi- cant revenue opportunities through the repackaging and sale of such copyrighted products in the new technological for- mat. Accordingly, such intangible assets have significant off-balance sheet asset value that is not fully refiected in the consolidated balance sheets of Time Warner and the Entertainment Group. 52 ri�tF vi,;��r��.�; ��:r: ip�.ry �,r:rdun� kl ��U�„ Filmed Entertainment Backlog Backlog represents the a��ount of future revenue not yet recorded from cash contracts for the licensing of theatrical and television product for pay cable, basic cable, network and syndicated television exhibition. Backlog of TWE's Filmed Entertainment-Warner Bros. division amounted to $2.298 billion at December 31, 1998 (including amounts relating to the licensing of film pro- duct to Time Warner's and TWE's cable television networks of $769 million). In addition, backlog of Time Warner's Filmed Entertainment-TBS division amounted to $636 million at December 31, 1998 (including amounts relating to the licensing of film product to Time Warner's and TWE's cable television networks of $226 million). Because backlog generally relates to contracts for the licensing of theatrical and television product which have already been produced, the recognition of revenue for such completed product is principally only dependent upon the commencement of the availability period for telecast under the terms of the related licensing agreement. Cash licensing fees are received periodically over the term of the related licensing agreements or on an accelerated basis using TWE's $500 million securitization facility. The portion of backlog for which cash has not already been received has significan? off-balance sheet asset value as a source of future funding. The backlog excludes advertising barter contracts. �vhich are also expected to result in the future realization of revenues and cash through the sale of advertising spots received under such contracts. INTEREST RATE AND FOREIGN CURRENCY RISK MANAGEMENT Interest Rate Swap Contracts Time Warner uses interest rate swap contracts to adjust the proportion of total debt that is sub- ject to variable and fixed interest rates. At December 31, 1998, Time Warner had interest rate swap contracts to pay floating- rates of interest (average six-month LIBOR rate of 5.5%) and receive fixed-rates of interest (average rate of 5.5%) on $1.6 billion notional amount of indebtedness, which resulted in approximately 37% of Time Warner's underlying debt, and 39% of the debt of Time Warner and the Entertainment Group combined, being subject to variable interest rates. At Decem- ber 31, 1997, Time Warner had interest rate swap contracts on $2.3 billion notional amount of indebtedness. Based on Time Warner's variable-rate debt and related interest rate swap contracts outstanding at December 31, 1998, each 25 basis point increase or decrease in the level of interest rates would, respectively, increase or decrease Time Warner's annual interest expense and related cash payments by approximately $11 million, including $4 million related to interest rate swap contracts. Such potential increases or decreases are based on certain simplifying assumptions; including a constant levei of variable-rate debt and related interest rate swap contracts during the period and, for all maturities, an immediate, ac�oss-the-board increase or decrease in the level of interest rates with no other subsequent changes for the remainder of the period. Foreign Exchange Cont�acts Time Warner uses foreign exchange contracts primarily to hedge the risk that unremitted or future royalties and license fees owed to Time Warner or TWE domestic companies for the sale or anticipated sale of U.S. copyrighted products abroad may be adversely affected by changes in foreign currency exchange rates. As part of its overall strategy to manage the level of exposure to the risk of foreign currency exchange rate fluctuations, Time Warner hedges a portion of its and TWE's combined foreign currency exposures anticipated over the ensuing twelve month period. At December 31, 1998, Time Warner had effectively hedged approximately half of the combined estimated foreign currency exposures that principally relate to anticipated cash flows to be remitted to the U.S. over the ensuing twelve month period. To hedge this exposure, Time Warner used foreign exchange contracts that generally have maturities of three months or less, which generally will be rolled over to provide continuing cover- age throughout the year. Time Warner is reimbursed by or reim- burses NVE for Time Warner contract gains and losses related to TWE's foreign currency exposure. Time Warner often closes foreign exchange sale contracts by purchasing an offsetting purchase contract. At December 31, 1998, Time Warner had contracts for the sale of $755 million and the purchase of $259 million of foreign currencies at fixed rates, compared to contracts for the sale of $507 mi�lion and the purchase of $139 million of foreign currencies at December 31, 1997. Based on the foreign exchange contracts outstanding at December 31, 1998, each 5% devaluation of the U.S. dollar as compared to the level of foreign exchange rates for currencies under contract at December 31, 1998 wouic result in approximately $38 million of unrealized Iosses and $13 miilion of unrealized gains on foreign exchz�ge contracts involving foreign currency sales and purchases. respectively. Conversely, a 5% appreciation of the U.S. dolla- would result in $38 million of uncealized gains and S� 3 m� - lion of unrealized losses, respectively. With regard :o :�e net $25 miliion of unrealized losses or gains on fore �n exchange contracts, Time Warner would be reimbursed by TWE, or would reimburse TWE, respectively, for app��xi- mately $10 million, net, related to TWE's foreign cu�•�ncy exposure. Consistent with the nature of the econom;c hedge provided by such foreign exchange contracts, such ��-eal- ized gains or losses would be offset by correspono ^�� decreases or increases, respectively, in the dollar va:,,a o` future foreign currency royalty and license fee pay^-�«�ts �I-a: wouid be received in cash within the ensuing twelve Mon?h period from the sale of U.S. copyrighted products a��oad. �.. ,...,... �„,.,.,.,�, _.. ,. 53 GLOBAL FINANCIAL MARKETS During 1998, certain financial markets, mainly Brazil, Russia and a number of Asian countries, experienced significant instability. Because less than 5% of the combined revenues of Time Warner and the Entertainment Group are derived from the sale of products and services in these countries, management does not believe that the state of these finan- cial markets poses a material risk to the operations of Time Warner and the Entertainment Group. EURO CONVERSION Effective January 1, 1999, the "euro" was established as a single currency valid in more than two-thirds of the member countries of the European Union. These member countries have a three-year transitional period to physically convert their sovereign currencies to the euro. By July 1, 2002, all partici- pating member countries must eliminate their currencies and replace their legal tender with euro-denominated bills and coins. Notwithstanding this transitional period, many commer- cial transactions are expected to become euro-denominated well before the July 2002 deadline. Accordingly, Time Warner continues to. evaluate the short-term and long-term effects of the euro conversion on its European operations, principally publishing, music, cable netv✓orks and filmed entertainment. Time Warner believes that the most significant short-term impact of the euro conversion is the need to modify its accounting and information systems to handle an increasing volume of transactions during the transitional period in both the euro and sovereign currencies of the participating mem- ber countries. Time Warner has identified its accounting and information systems in need of modification and an action pian has been formulated 'to address the nature and timing of remediation efforts. Remediation efforts have begun and the plan is expected to be substantially completed well before the end of the transitional period. This timetable wiil be adjusted, if necessary, to meet the anticipated needs of Time Warner's vendors and customers. Based on preliminary information, costs to modify its accounting and information systems are not expected to be material. Time Warner believes that the most significant long-term business risk of the euro conversion may be increased pricing Sa iII,A[ WARfJ(I:INC I!�4Al�NN�)AI. Hfl'(J(:1 pressures for its products and services brought about by heightened consumer awareness of possible cross-border price differences. However, Time Warner believes that these business risks may be offset to some extent by lower mate- rial costs, other cost savings and marketing opportunities. Notwithstanding such risks, management does not believe that the euro conversion will have a material effect on Time Warner's financial position, results of operations or cash flows in future periods. YEAR 2000 TECHNOLOGY PREPAREDNESS Time Warner, together with its Entertainment Group and like most large companies, depends on many different computer systems and other chip-based devices for the continuing conduct of its business. Older computer programs, computer hardware and chip-based devices may fail to recognize dates beginning on January 1, 2000 as being valid dates, and as a result may fail to operate or may operate improperly when such dates are introduced. Time Warner's exposure to potential Year 2000 problems arises both in technological operations under the control of the Company and in those dependent on one or more third par- ties. These technological operations include information tech- nology ("IT") systems and non-IT systems, including those with embedded technology, hardware and software. Most of Time Warner's potential Year 2000 exposures are dependent to some degree on one or more third parties. Failure to achieve high levels of Year 2000 compliance could have a material adverse impact on Time Warner and its financial statements. The Company's Year 2000 initiative is being conducted at the operational level by divisional project managers and senior technology executives overseen by senior divisional executives, with assistance internally as well as from outside professionals. The progress of each division through the different phases of remediation—inventorying, assessment, remediation planning, implementation and final testing— is actively overseen and reviewed on a regular basis by an executive oversight group that reports through the Com- pany's Chief Financial Officer to the Audit Committee of the Board of Directors. The Company has generaily completed the process of identifying potential Year 2000 difficulties in its technological operations, including IT applications, IT technology and sup- port, desktop hardware and software, non-IT systems and important third party operations, and distinguishing those that are "mission critical" from those that are not An item is considered "mission critical° if its Year 2000-related failure would significantly impair the ability of one of the Company's major business units to (1) produce, market and distribute the products or services that generate significant revenues for that business, (2) meet its obligations to pay its employees, artists, vendors and others or (3) meet its obligations under regulatory requirements and intemal accounting controls. The Company and its divisions, including the Entertainment Group, have identified approximately 1,000 worldwide, "mission criti- cal" potential exposures. Of these, as of December 31, 1998, approximately 39% have been identified by the divisions as Year 2000 compliant, approximately 46% as in the remedia- tion implementation or final testing stages, approximately 14% as in the remediation planning stage and less than 1% as still in the assessment stage. The Company currently expects that the assessment phase for the few remaining potential exposures shouid be completed during the first quarter of 1999 and that remediation with respect to approximately 80% of all these identifiied operations will be substantially completed in all material respects by the end of the second quarter of 1999. The Company, however, could experience unexpected delays. The Company is currently planning to impose a"quiet" period at the beginning of the fourth quarter of 1999 during which any remaining remedia- tion invoiving installation or modification of systems that interface with other systems will be minimized to permit the Company to conduct testing in a stable environment. As stated above, however, the Company's business is heavily dependent on third parties and these parties are them- selves heavily dependent on technology. In some cases, the Company's third party dependence is on vendors of technofogy who are themselves working towards solutions to Year 2000 problems. For example, in a situation endemic to the cable industry, �uch of the Company's headend equipment that con- trols cable set-top boxes was not Year 2000 compliant as of December 31, 1998. The box manufacturers are working with cable industry groups and have developed solutions that the Company is installing in its headend equipment It is currently expected that these solutions will be substantially implemented by the end of the second quarter of 1999. In other cases, the Company's third party dependence is on suppliers of products or services that are themselves computer-intensive. For exam- ple, if a television broadcaster or cable programmer encounters Year 2000 problems that impede its ability to deliver its pro- gramming, the Company will be unable to provide that pro- gramming to its cable customers. Similarly, because the Company is also a programming supplier, third-party signal delivery problems could affect its ability to deliver its program- ming to its customers. The Company has attempted to include in its "mission critical" inventory significant service providers, vendors, suppliers, customers and governmentai entities that are believed to be critical to business operations and is in vari- ous stages of ascertaining their state of Year 2000 readiness through various means, including questionnaires, interviews, on-site visits, system interface testing and industry group participation. Moreover, Time Warner is dependent, like all large companies, on the continued functioning, domestically and internationally, of basic, heavily computerized services such as banking, telephony and power, and various distribution mechanisms ranging from the mail, railroads and trucking to high-speed data transmission. Time Warner is taking steps to attempt to satisfy itself that the third parties on which it is heavily reliant are Year 2000 compliant or that alternate means of ineeting its requirements are available, but cannot predict the likelihood ot such compliance nor the direct or indirect costs to the Company of non-compliance by those third parties or of securing such services from alternate compiiant third parties. In areas in which the Company is uncertain about the antici- pated Year 2000 readiness of a significant third party, the Company is investigating available alternatives, if any. The Company, including the Entertainment Group, cur- rently estimates that ��ie aggregate cost of its Year 2000 remediation program, which started in 1996, will be approxi- mately $125 to $175 million, of which an estimated 45o/o to 55% has been incurred through December 31, 1998. These costs include estimates of the costs of assessment, replace- ment, repair and upgrade, both planned and unplanned, of certain IT and non-IT systems and their implementation and testing, The Company anticipates that its remediation pro- gram, and related expenditures, may continue into 2001 as. temporary solutions to Year 2000 problems are replaced with upgraded equipment. These expenditures have been and are expected to continue to be funded from the Company's oper- ating cash flow and have not and are not expected to impact materially the Company's financial statements. Management believes that it has established an effective program to resolve all significant Year 2000 issues in its control in a timely manner. As noted above, however, the Company has not yet completed all phases of its program and is dependent on third parties whose progress is not within its control. In the event that the Company does not complete any of its currently planned additional remediation prior to the Year 2000, managemenf believes that the Company could experience significant difficulty in producing and delivering its products and services and conducting its business in the Year 2000 as it has in the past. In addition, disruptions experienced by third parties with which the Company does business as well as by the economy gener- ally could also materially adversely affect the Company. The amount of potential liability and lost revenue cannot be reasonably estimated at this time. The Company has been focusing its efforts on identifica- tion and remediation of its Year 2000 exposures and has not yet developed significant, specific contingency plans in the event it does not successfully complete all phases of its Year 2000 program. The Company, however, has begun to exam- ine its existing standard business interruption strategies to evaluate whether they would satisfactorily meet the demands of failures arising from Year 2000-related problems. The Company intends to examine its status periodically to deter- mine the necessity of establishing and implementing such contingency plans or additional strategies, which could involve, among other things, manual workarounds, adjusting staffing strategies and sharing resources across divisions. 56 �iisL ��:.R�<CRU,C �99a:.a�nluni REPORi CAUTION CONCERNING FORWARD- LOOKING STATEMENTS The Securities and Exchange Commission encourages companies to disclose forward-looking information so that investors can better understand a company's future prospects and make informed investment decisions. This document, together with management's public commentary related thereto, contains such "forward-looking statements" within the meaning of the Privafe Securities Litigation Reform Act of 1995, particularly statements anticipating future growth in revenues, EBITA and cash fiow. Words such as "anticipate; "estimate," "expects," "projects," "intends;' "plans," "believes" and words and terms of similar substance used in connection with any discussion of future operating or financial performance identify such forward-looking state- ments. Those forward-looking statements are management's present expectations of future events. As with any projection or forecast, they are inherently susceptible to changes in circumstances, and the Company is under no obligation to (and expressly disclaims any such obligation to) update or alter its forward-looking statements whether as a result of such changes, riew information or otherwise. Time Warner operates in highly competitive, consumer driven and rapidly changing media and entertainment busi- nesses that are dependent on government regulation and economic, political and social conditions in the countries in which they operate, consumer demand for their products and services, technological developments and (particularly in view of technological changes) protection of their intellectual property rights. Time Warner's actual results could differ materially from management's expectations because of changes in such factors. Some of the other factors that also could cause actual results to differ from those contained in the forward-looking statements include those identified in Time Warner's other filings and: ■ For Time Warner's cable business, more aggressive than expected competition from new technologies and other types of video programming distributors, including OBS; increases in government regulation of cable or equipment rates (or any failure to reduce rate regulation as is presently mandated by statute) or other terms of service (such as "dig- ital must-carry" or "unbundling" requirements); increased dif- ficulty in obtaining franchise renewals; the failure of new equipment (such as digital set-top boxes) or services (such as high-speed online services or telephony over cable or video on demand) to function properly, to appeal to enough consumers or to be available at reasonable prices and to be delivered in a timely fashion; and greater than expected increases in programming or other costs. ■ For Time Warner's cable programming and television businesses, greater than expected programming or production costs; public and cable operator resistance to price increases (and the negative impact on premium programmers of increases in basic cable rates); increased regulation of distribution agreements; the sensitivity of advertising to economic cyclicality; and greater than expected fragmentation of consumer viewership due to an increased number of programming services or the increased popularity of alternatives to television. ■ For Time Warner's film and television businesses, their ability to continue to attract and select desirable talent and scripts at manageable costs; increases in production costs generally; fragmentation of corisumer leisure and entertain- ment time (and its possible negative effects on the broad- cast and cable networks, which are significant customers of these businesses); continued popularity of inerchandising; and the uncertain impact of technological developments such as DVD and the Internet. ■ For Time Warner's music business, its ability to continue to attract and select desirable talent at manageable costs; the timely completion of albums by major artists; the popular demand for particular artists and albums; its ability to con- tinue to enforce its intellectual property rights in digital envi- ronments; and the overall strength of global music sales. ■ For Time Warners print media and publishing businesses, increases in paper and distribution costs; the introduction and increased popularity of alternative technologies for the provi- sion of news and information, such as the Internet; and fluctu- ations in advertiser and consumer spending. ■ The ability of the Company and its key service providers, vendors, suppliers, customers and governmental entities to replace, modify or upgrade computer systems in ways that adequately address the Year 2000 issue, including their ability to identify and correct all relevant computer codes and embedded chips, unanticipated difficulties or delays in the implementation of the Company's remediation plans and the ability of third parties to address adequately their own Year 2000 issues. in addition, 7ime Warner's overall financial strategy, including growth in operations, maintaining its financial ratios and strengthened balance sheet, could be adversely affected by increased interest rates, failure to meet earnings expecta- tions, significant acquisitions or other transactions, conse- quences of the euro conversion and changes in Time Warners plans, strategies and intentions. tiit�. w:,r,ri! r, in�C t�i��it nr:•.�,i;.i r>I �'h-.:� 57 Consolidated Baiance Sheet December 31, (millions, except per share amounts) 1998 ASSETS — Current assets Cash and equivalents Receivables, less allowances of $1.007 billion and $991 million Inventories Prepaid expenses Total current assets Noncurrent inventories Investments in and amounts due to and from Entertainment Group Other investments Property, plant and equipment, net Music catalogues, contracts and copyrights Cable television and sports franchises Goodwill Other assets Total assets �JB TIM[ WIRNFR INC �9y& AfJNUAL Rt"PO?' $ 442 2,885 946 1,176 5,449 1,900 4,980 794 1,991 876 2,868 11,919 863 $31,640 1997 $ 645 2,447 830 1,089 5,01 1 1,766 5,549 1,495 2,089 928 3,982 12, 572 77' � 34,163 � LIABILITIES AND SHAREHOLDERS' E(lUITY Current liabilities Accounts payable Participations, royalties and programming costs payable Debt due within one year Other current liabilities — -----.._..___`.._.._..---...__..__........_._._.__._...--�--...._._.__._..._..,......._.__.. Total current liabilities Long-term debt Borrowings against future stock option proceeds Deferred income taxes Unearned portion of paid subscriptions Other liabilities Company-obligated mandatorily redeemable preferred securities of a subsidiary holding solely subordinated debentures of a subsidiary of the Company Series M exchangeable preferred stock, $.10 par value, 1.9 million shares outstanding in 1997 with a$1.903 billion liquidation preference 1998 $ 996 1,199 19 2,404 _....._ ._......_.__. 4,618 10,925 895 3,491 741 1,543 575 1997 $ 912 1.072 8 2,379 _.......4,371 t 1,833 533 3,960 672 1,006 575 1, 857 Shareholders' equity Preferred stock, $.10 par value, 22.6 and 35.4 million shares outstanding, $2260 and $3.539 billion liquidation preference 2 4 Series LMCN-V Common Stock, $.01 par value, 57.1 miliion shares outstanding 1 i Common stock, $.01 par value, 1.1 18 and 1.038 billion shares outstanding 11 10 Paid-in capital 13,134 i 2,675 Accumulated deficit (4,296) (3,33a) _.. __....__ .. . .._ . _.. .. .._...._ .. . . _..... _ _ _ _... . .._ . ... .. . Total shareholders' equity 8,852 9,356 _...._ . ........ ... ... ..... .. ........_... . __ _._. .. .. Total liabilities and shareholders' equity $31,640 $34,163 See accompanying notes. ,i�,� v:i.i:i�i r, i;,r ,�i��; n�aw��;,i i.� ivi:: 59 Consolidated Statement of Operations Years Ended December 31, (millions, except per share amounts) �ggg �gg� 1996 Revenues(a) . ...... ... $14,582 $ i 3,294 $10,064 _. . _ . ..................._............................................_........................................................................................................................................ Cost of revenues(a)(b) _........... _.._. .............8,21.0..............................................7542................_.............. 5,922 Selling, generai and administrative�a��b� 4,876 4,481 _ ..... . .. . ....... _...... . t _.. ...__.. _ ...._ . .. _ _P.. 9..... P ........ _ . _._.... . .. . _ . ..... .. 13,086 12,023 _...._.....9.098 0 eratm ex enses _.._ ...... ............_......................__._ ..........__....___...................._..........................._966 Business segment operating income 1,496 1,271 Equity in pretax income of Entertainment Group�a� 356 ggg 290 Interest and other, net�a� (1,180) (1,044) (1,174) Corporate expenses�a> (86) ---..........._...- --- .......... ...... ....._.. ........... .. _ (81) (�g) _.. . ....... _ _.. ncome be ore income taxes 586 832 4 Income taxes (418) (531) (160) _..... _ ....... . . . . ...... ...... . . ..... _ .... ... . .......... .,. . ... ....,. _._.... __.._ . .... . . .. . ....... . ... .. . ....... .. . . . ......... .. . ..... ...._........ Income (loss) before extraordinary item 168 301 (t56) Extraordinary loss on retirement of debt, net of $37 and $22 million income tax benefit in 1997 and 1996 respectively — (55) (35) _ . _ .. Net income (loss) 168 246 (191) Preferred div�dend requ�rements<<� (540) (319) (25�) _. _... ..... Net loss applicable to common shares � $(372) $ (73) $(448) Basic and diluted loss per common share: Loss before extraordinary item $ (.31) $ (.01) $ (.48) Net loss $ (.31) $ (.06) $ (.52) Average common shares 1,194.7 1,135.4 gg2.q (a) Includes the follow�ng �ncome (expenses) resulling from transactions with the EnteRainment Group and other related compan:es for the years ended December 31, 1998, 1999 and 1996, respectively revenuer$487 mill�on, $384 million and $224 million; cost of revenues-$(322) m�IFO^. 5(245) million and $(177) mdiion; selling, general and administra- t:ve-5(40) million. $(53) million and 334 mil6on; equity in pretax income of Entertainment Group-$105 ms`c^,. $5 million and $(29) million: interest and other, net-$(9) million, 5(36) million and $(33) mlllion; and corporate expenses-$72 million, $72 million and $69 mill�on (Note 18) (b) Icciudes deprecia!ion and amortizatwn expense of: $ 1�� ]g $ � 294 $ 988 (c) Preferred dividend requirements (or 1996 include a one-time effect of $234 million ($.19 loss per common scae) relating to the premium paid in connection with the redemption c! the Company's 10;'-°'o Ser�es M eschangeable preferred stock ("Series M Preferred Srock") at an aggregz:e cost of app�oz�mately $2.1 b�lfon (Note 11). See accompanying notes. s� . ..:- IVr:HIVf'.!2 I�(' ��+.I;i l�lllJl;/�I (."f'(112', Consolidated Statement of Cash Flows Years Ended December 31, (millions) Operations Net income (loss) Adjustments for noncash and nonoperating items: Extraordinary loss on retirement of debt Depreciation and amortization Noncash interest expense Excess (deficiency) of distributions over equity in pretax income of Entertainment Group Equity in losses (income) of other investee companies after distributions Changes in operating assets and liabilities: 1998 1997 $ 168 $ 246 — 55 1,178 1,294 30 98 342 (207) 147 36 Receivables (597) (167) Inventories (312) (84) Accounts payable and other liabilities 810 501 Other balance sheet changes 79 (364) . ......... ...... . . . ... ...._......_ ................. . ..................... ...... .... __. __. _. __ ._ .. ... . .......... _ . _.... Cash provided by operations 1,845 1,408 _._. _ .... . .. . ................�.... ..... . _....... ... ..._...... ... .. _ _ _ _... .. . _ _ .._........ . ..... ... _.,...... Investing Activities Investments and acquisitions Capital expenditures Investment proceeds Proceeds received from distribution of TWE Senior Capital _. _ .... . ... . . .......... . . .... _.... .. . ........ _................ _ Cash provided (used) by investing activities _.... _...._... � Financing Activities Borrowings Debt repayments Borrowings against future stock option proceeds ' Repayments of borrowings against future stock option proceeds Repurchases of Time Warner common stock Redemption of Series M Preferred Stock Issuance of Series M Preferred Stock Dividends paid Proceeds received from stock option and dividend reinvestment plans Other, principally financing costs _ . _ _ _.. . Cash used by financing activities _ .. _. .. __ Increase (Decrease) in Cash and Equivalents Cash and Equivalents at Beginning of Period�a� _ .. . . ...... ........ _.. _._. . _ .. Cash and Equivalents at End of Period�a� (a) Includes current and noncurrent cash and equ�valents at December 3�, t 996 and i 995 See accompany�ng notes. (159) (512) 569 455 _.._... 353 3,743 (2,317) 1,015 (653) (2,240) (2,093) (524) 740 (72) (2,401) (203) 645 $ 442 (113) (574) 187 455 (45) 5.413 (6,394) 230 (185) (344) (338) 454 (68) (1,232) 131 514 $ 645 1996 $ (191) 35 988 96 (62) (53) (39) (180) (408) 67 253 ..._.. (261) (481) 318 (424) 3,431 (5,271) 488 (456) 1,550 (287) 105 (60) (500) (671) 1,185 5 514 ir_�� ,.. �. .�,.. ��vr,a•.•.. ...:,n��;� 67 i Consolidated Statement of Shareholders' Equity Preferred Common Paid-In Accumulated (millions) Stock Stock Capital Deficit Total Balance at December 31, 1995 $ 30 $776 $ 5,034 $(2,173) $ 3,667 Net loss �191� �t91� Increase in unrealized gains on securities, net of $11 million tax expense 17 17 Foreign currency translation adjustments 9 9 Comprehensiveincome iloss). _....._._,..----- .......................�....................._........._._........_......................................_......_.._..__._._...---.............................................................._..._.................... _............._..._.�165�..............._............._.(�65) Common stock dividends (155) (155) Preferred stock dividends (257) (257) Issuance of common and preferred stock in the CVI acquisition 6 6 668 680 Reduction in par value of common and preferred stock due to TBS Transaction (32) (774) 806 — Issuance of common stock in the TBS Transactiun 3 6,024 6,027 Repurchases of Time Warner common stock (456) (456) Shares issued pursuant to stock option, dividend reinvestment and benefit plans i 63 (8) � 55 Other . .........� .............................._.:._.._........................._. 6 g .....---. ._ ... ....... . ... __ ...... ..... _ _._... _ _.... alance at December 31, 1996 4 11 12,245 (2,758) 9,502 Net income 246 246 Decrease in unrealized gains on securities, net of $89 million tax benefit�a> (128) (128) Foreign currency translation adjustments ..:.....,, (76) (76) Comprehensive income (loss) � a2 42 Common.stock dividends (204) (20a) Preferred stock dividends (319) (319) Issuance of common stock in connection with the TBS Transaction 67 67 Repurchases of Time Warner common stock (3a4) (344) Shares issued pursuant to stock option, dividend reinvestment and benefit plans 7� 1 (98) 613 Other (4) 3 (t) _ .... ...... . ...... .. ..... ......... _......... _. _... _.. _._ _._ a ance at ecember 31, 1997 4 11 t2,675 (3,334) 9,356 Net income 168 168 Foreign currency translation adjustments 4 4 Increase in realized and unrealized losses on derivative financial instruments, net of $13 million tax benefit (20) (20) Cumulative effect of change in accounting for derivative finanaal instruments net of $3 million tax benefit ��a� �18� _. _.._ .. . . Comprehensive income (loss) 134 t 34 Common stock dividends (2�6) (2t6) Preferred stock dividends (540) (540) Issuance of common stock in connection with the conversion of zero-coupon convertible notes due 2013 1,150 t, t 50 Issuance of common stock in connection with the conversion of convertible preferred stock (2) t t51 (150) — Repurchases of Time Warner common stock (1) (2,239) (2,240) Shares issued pursuant to stock option, dividend reinvestment and benefit plans 1 1,397 (190) t,208 Balance at December 31, 1998 $ 2 $ 12 $ t 3,134 $(4,296) $ 8,852 (a) Includes a$13 miliion reduction (net of a$9 m�ltlon tax ellect) related to reahzed gams on the sale of securit�es in 1999 In pnnr �r.neds, th:s amount was induded in comprehensrve income as a component oi T�nie Warner'; uniealized gains on secunties, See accompanying notes. 62 TIMf W�RNER WC 1998 nNNUni. RFPORi Notes to Consolidated Financial Statements 1. ORGANIZATION AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES Description of Business Time Warner Inc. ("Time Warner° or the "Company"), together with its consolidated and uncon- solidated subsidiaries, is the world's leading media and enter- tainment company. Time Warner's principal business objective is to create and distribute branded information and entertain- ment copyrights throughout the world. Time Warner classifies its business interests into four fundamental areas: Cable Networks, consisting principally of interests in cable television programming; Publishing, consisting principally of interests in magazine publishing, book publishing and direct marketing; Entertainment, consisting principally of interests in recorded music and music publishing, filmed entehainment, television production and television broadcasting; and Cab/e, consisting principally of interests in cable television systems. A majority of Time Warner's interests in filmed entertainment, television production, television broadcasting and cable tele- vision systems, and a portion of its interests in cable television programming are held through Time Warner Entertainment Company, L.P. ("TWE"). Time Warner owns general and limited partnership interests in TWE consisting of 74.49% of the pro rata priority capital ("Series A Capital") and residual equity capi- tal ("Resid.ual Capital"), and 100% of the senior priority capital ("Senior Capital") and junior priority capital ("Series B Capital"). The remaining 25.51% limited partnership interests in the Series A Capital and Residual Capital of TWE are held by a subsidiary of MediaOne Group, Inc. ("MediaOne"), formerly U S WEST, Inc. Time Warner does not consolidate TWE and certain related companies (the "Entertainment Group") for financial reporting purposes because of certain limited partnership approval rights related to TWE's interest in certain cable television systems. Each of the business interests within Cable Networks, Publishing, Entertainment and Cable is important to man- agemenYs objective of increasing shareholder value through the creation, extension and distribution of recognizable brands and copyrights throughout the world. Such brands and copy- rights include (1) leading cable television networks, such as HBO, Cinemax, CNN, TNT and the TBS Superstation, (2) magazine franchises such as Trme, People and Sports lllustrated and direct marketing brands such as Time Life Inc. and Book-of-the-Month Club, (3) copyrighted music from many of the world's leading recording artists that is produced and distributed by a family of established record labels such as Warner Bros. Records, Atlantic Records, clektra Entertainment and Warner Music International, (4) unique and extensive film, television and animation libraries of Warner Bros. and Turner Broadcasting System, Inc. ("TBS°), and trademarks such as the Looney Tunes characters, Batman and The Flintsfones, (5) The WB Network, a national broadcasting networ�c launched in 1995 as an exten- sion of the Warner Bros. brand and as an additional distribution outlet for the Company's collection of children's ca�toons and television programming and (6) Time Warner Cable, currently the largest operator of cable television systems in the U.S. The operating results of Time Warner's various business interests are presented herein as an indication of financial performance (Note 16). Except for start-up losses incurred in connection with The WB Network, Time Warner's principal business interests generate significant operating income and cash flow from operations. The cash flow from operations generated by such business interests is considerably greater than their operating income due to significant amounts of noncash amortization of intangible assets recognized in various acquisitions accounted for by the purchase method of accounting. Noncash amortization of intangible assets recorded by Time Warner's business interests, including the unconsolidated business interests of the Entertainment Group, amounted to $1.309 billion in 1998, $1.342 billion in 1997 and $1.1 17 billion in 1996. Basis of Presentation The consolidated financial statements of Time Warner reflect the acquisition on October 10, 1996 of the remaining 80% interest in TBS that it did not already own and certain cable-related transactions, as more fully described herein (Notes 2 and 3). As a result of the acquisi?ion of TBS. a new parent company with the name "Time Warner Inc" replaced the oId parent company of the same name (now known as Time Warner Companies, Inc., "TW Companies"), and NV Companies and TBS became separate, wholly ownec subsidiaries of the new parent company. References herein to "Time Warner" or the "Company" refer to TW Companies prior to October 10, 1996 and Time Warner Inc. thereafter. Common stock, paid-in-capital, stock options, per com- mon share and average common share amounts for all prior periods have been restated to give effect to a two-ror-one common stock split that occurred on December 15, 1998. In addition, certain reclassifications have been made to `he prior years' fmanciat statements to conform to the 1998 presentation. riuF wnFaFa wC �908 nN�: ::.�. Kr r>or,i 63 Basis of Consolidation and Accounting for Investments The consolidated finanaa� statements include 100% of the assets, liabilities, revenues, expenses, income, loss and cash flows of Time Warner and all companies in which Time Warner has a controlling voting interest ("subsidiaries"), as if Time Warner and its subsidiaries were a single company. Significant intercompany accounts and transactions between the consoli- dated companies have been eliminated. Significant accounts and transactions between Time Warner and the Entertainment Group are disclosed as related party transactions (Note 18). The Entertainment Group and investments in certain other companies in which Time Warner has significant influence, but less than a controlliny voting interest, are accounted for using the equity method. Under the equity method, only Time Warner's investment in and amounts due to and from the equity investee are included in the consolidated balance sheet, only Time Warner's share of the investee's earnings is included in the consolidated operating results, and only the dividends, cash distributions, loans or other cash received from the investee, less any additional cash investments, loan repay- ments or other cash paid to the investee are included in the consolidated cash flows. Investments in companies in which Time Warner does not have a controlling interest or an ownership and voting inter- est so large as to exert significant influence are accounted for at market value if the investments are publicly traded and there are no resale restrictions, or at cost, if the sale of a publicly-traded investment is restricted or if the investment is not publicly traded. Unrealized gains and losses on invest- ments accounted for at market value are reported net-of-tax in accumulated deficit until the investment is sold, at which time the realized gain or loss is included in income. Dividends and other distributions of eamings from both market value and cost method investments are included in income when declared. The effect of any changes in Time Warner's ownership interests resulting from the issuance of equity capital by consolidated subsidiaries or equity investees to unaffiliated parties is included in income. Foreign Currency Translation The financial position and operating results of substantially all foreign operations are con- solidated using the local currency as the functional currency. Local currency assets and liabilities are translated at the rates of exchange on the balance sheet date, and local currency revenues and expenses are translated at average rates of 64 !iNF wnRnFR iNC �9'a8:•r�nIUAI k[�'Ok' exchange during the period. Resulting translation gains or losses, which have not been material, are included in accumu- lated deficit. Use of Estimates The preparation of financial statements in conformity with generally accepted accounting principles requires management to make estimates and assumptions that affect the amounts reported in the financial statements and footnotes thereto. Actual results could differ from those estimates. Significant estimates inherent in the preparation of the accompanying consolidated financial statements include management's forecast of anticipated revenues from the sale of future and existing music and publishing-related products, as well as from the distribution of theatricai and television product, in order to evaluate the ultimate recover- ability of accounts receivables, film inventory and artist and author advances recorded as assets in the consolidated bal- ance sheet. Accounts receivables and sates in the music and publishing industries, as well as sales of home video product in the filmed entertainment industry, are subject to cus- tomers' rights to return unsold items. Management periodi- cally reviews such estimates and it is reasonably possible that management's assessment of recoverability of accounts receivables, individual films and television product and indi- vidual artist and author advances may change based on actual results and other factors. Revenues and Costs Publishing and Music The unearned portion of paid magazine subscriptions is deferred until magazines are delivered to subscribers. Upon each delivery, a proportionate share of the gross subscription price is included in revenues. Magazine ad•�ertis�ng revenues are recognized when the advertisements are published. In accordance with industry practice, certain products (such as magazines, books, home videocassettes, compact discs and cassettes) are sold to customers with the right to return unsold items. Revenues from such sales are recog- nized when the products are shipped based on gross sales less a provision for future returns. Inventories of magazines, books, cassettes and compact discs are stated at the lower of cost or estimated realizable value. Cost is determined using first-in, first-out; last-in, first- out; and average cost methods. Returned goods included in inventory are valued at estimated realizabie value, but not in excess of cost. Cab/e and Cab/e Networks A significant portion of cable system and cable network pro gramming revenues are derived from subscriber fees and advertising. Subscriber fees are recorded as revenue in the period the service is provided and advertising revenues are recognized in the period that the advertisements are exhibited. The costs of rights to exhibit feature films and other program- ming on the cable networks during one or more availability periods ("programming costs") generally are recorded when the programming is initially available for exhibition, and are allocated to the appropriate availability periods and amor- tized as the programming is exhibited. Filmed Enterfainment Feature films are produced or acquired for initial exhibition in theaters followed by distribution in the home video, pay cable, basic cable, broadcast network and syndicated televi- sion markets. Generally, distribution to the theatrical, home video and pay cable markets (the primary markets) is princi- pally completed within eighteen months of initial release. Thereafter, feature films are distributed to the basic cable, broadcast network and syndicated television markets (the secondary markets). Theatrical revenues are recognized as the films are exhibited. Home video revenues, less a provision for returns, are recognized when the home videos are� sold. Revenues from the distribution of theatrical product to cable, broadcast network and syndicated television markets are recognized when the films are available to telecast Television films and series are initially produced for the networks or first-run television syndication (the primary markets) and may be subsequently licensed to foreign or domestic cable and syndicated television markets (the sec- ondary markets). Revenues from the distribution of television product are recognized when the films or series are available to telecast, except for barter agreements where the recogni- tion of revenue is deferred unti� the related advertisements are exhibited. License agreements for the telecast of theatrical and television product in the cable, broadcast network and syndi- cated television markets are routinely entered into well in advance of their available date for telecast, which is generally determined by the telecast privileges granted under previous license agreements. Accordingly, there are significant contrac- tual rights to receive cash and barter under these licensing agreements. For cash contracts, the related revenues will not be recognized until such product is available for telecast under the contractual terms of the related license agreement. For barter contracts, the related revenues will not be recog- nized until the product is available for telecast and the adver- tising spots received under such contracts are either used or sold to third parties. All of these contractual rights for which revenue is not yet recognizable is referred to as "backlog" Inventories of theatrical and television product are stated at the lower of amortized cost or net realizable value. Cost principally consists of direct production costs and production overhead. A portion of the cost to acquire TBS in 1996 was allocated to its theatrical and television product, including an allocation to purchased program rights (such as the anima- tion library of Hanna-Barbera Inc. and the former film and television libraries of Metro-Goldwyn-Mayer, Inc. and RKO Pictures, Inc.) and product that had been exhibited at least once in all markets ("Library"). Library product is amortized on a straight-line basis over twenty years. Individual films and series are amortized, and the related participations and residuals are accrued, based on the proportion that current revenues from the film or series bear to an estimate of total revenues anticipated from all markets. These estimates are revised periodically and losses, if any, are provided in full. Current film inventories generally include the unamortized cost of completed feature films allocated to the primary ., markets, television films and series in production pursuant to a contract of sale, film rights acquired for the home video market and advances pursuant to agreements to distribute third-party films in the primary markets. Noncurrent film inventories generally include the unamortized cost of com- pleted theatrical and television films allocated to the sec- ondary markets, theatrical films in production and the Library. P�oposed Changes to Film Accounting Standards In October 1998, the Accounting Standards Executive Committee of the Amer�can Institute of Certified Publ:c Accountants ( AcSEC") �ssued an exposure draft of a pro- posed Statement of Position, Accounting by Producers and Distributors of Films" (the "SOP"), The proposed rules would establish new accounting standards for producers and dis- tributors of films. Among its many provisions, the SOP �•�ould require revenue for the licensing of film and television produc* to be recognized generally over the term of the related agree- ment. This would represent a significant change to ex�s!ing industry practice, which generally requires such licens�ng revenue to be recognized when the product is first available for telecast. Th�s is because, after that date, licensors have no further significant obl�gations under the terms of the related licens�ng agreements. rin<e wn4�NFrt u;� �.��a nrirci;:,, , .. 65 � While the SOP's proposals in many other areas (i.e., advertising and film cost amortization) generally are consis- tent with Time Warner's accounting policies, this is not the case with the proposed changes in revenue recognition for licensed product. Adopting the proposed accounting stan- dards for licensed product would result in a significant one- time, noncash charge to earnings upon adoption that would be refiected as a cumulative effect of a change in account- ing principle. This one-time, noncash charge would be reversed in future periods as an increase to operating income when Time Warner re-recognizes the revenues asso- ciated with the licensing of its film and television product over the periods of the related licensing agreements. The SOP proposes an effective date of January 1, 2000 for cal- endar year-end companies, with earlier application encour- aged. The provisions of the SOP are still being deliberated by AcSEC and could change significantiy prior to the issuance of a final standard. Advertising In accordance with Financial Accounting Standards Board ("FASB") Statement No. 53, "F;;�ancial Reporting by Producers and Distributors of Motion Picture Films" advertising costs for theatrical and television product are capitalized and amortized over the related revenue streams in each market that such costs are intended to benefit; which generally does not exceed three months. Other advertising costs are expensed upon the first exhibition of the advertise- ment, except for certain direct-response advertising, for which the costs are capitalized and amortized over the expected period of future benefits. Direct-response advertising princi- pally consists of product promotional mailings, broadcast advertising, catalogs and other promotional costs incurred in the Company's direct-marketing businesses. Deferred advertising costs are generally amortized over periods of up to three years subsequent to the promotional event using straight-line or accelerated methods, with a significant portion of such costs amortized in twelve months or less. Deferred advertising costs for Time Warner amounted to $282 million and $244 million at December 31, 1998 and 1997, respec- tively. Advertising expense. excluding theatrical and television product, amounted to $1.154 billion in 1998, $1.080 billion in 1997 and $1.050 billion in 1996. 66 riM�� wr.ur�[�z r.�c iy".5 �.r,n�u.v, r,� ro„i Cash and Equivalents Cash equivalents consist of commer- ciai paper and other investments that are readily c�nvertible into cash and have original maturities of three months or less. Financial Instruments Effective July 1, 1998, Time Warner adopted FASB Statement No. 133, Accounting for Derivative Instruments and Hedging Activities" ("FAS 133"). FAS 133 requires that all derivative financial instruments, such as interest rate swap contracts and foreign exchange contracts, be recog- nized in the financial statements and measured at fair value regardless of the purpose or intent for holding them. Changes in the fair value of derivative financial instruments are either recognized periodically in income or shareholders' equity (as a component of comprehensive income), depending on whether the derivative is being used to hedge changes in fair value or cash flows. The adoption of FAS 133 did not have a material effect on Time Warner's primary financial statements, but did reduce comprehensive income by $18 million in the accompa- nying consolidated statement of shareholders' equity. The carrying value of Time Warner's financial instruments approximates fair value, except for differences with respect to long-term, fixed-rate debt (Note 7) and certain differences relating to cost method investments and other financial instruments that are not signi#icant. The fair value of financial instruments is generally determined by reference to market values resulting from trading on a national securities exchange or in an over-the-counter market. In eases where quoted market prices are not available, such as for derivative financial instru- ments, fair value is based on estimates using present value or other valuation techniques. Property, Plant and Equipment Properfy, plant and equip- ment are stated at cost. Additions to cable property, plant and equipment generally include material, labor, overhead and interest. Depreciation is provided generally on the straight-line method over useful lives ranging up to thirty years for build- ings and improvements and up to sixteen years for furniture, fixtures, cable television and other equipment. Property, piant and equipment consists of: December 31, (millions) 1998 1997 Land and buildings $ 963 $ 962 Cable television equipment 1,035 941 Furniture, fixtures and other equipment 1,400 1,337 3,398 3,240 Less accumulated depreciation (1,407) (1,151) ��. _-----..._..._...-----..__.........._..._.._._._._._._...__....---------- Total $ 1,991 $ 2,089 Intangible Assets As a creator and distributor of branded information and entertainment copyrights, Time Warner has a significant and growing number of intangible assets, including goodwill, cable television and sports franchises, film and tele- vision libraries, music catalogues, contracts and copyrights, and other copyrighted products and trademarks. In accor- dance with generally accepted accounting principles, Time Warner does not recognize the fair value of internally gener- ated intangible assets. Costs incurred to create and produce copyrighted p�oduct, such as feature films, television series and compact discs, are generally either expensed as incurred, or capitalized as tangible assets as in the case of cash advances and inventoriable product costs. However, account- ing recognition is not given to any increasing asset value that may be associated with the collection of the underlying copyrighted material. Additionally, costs incurred to create or extend brands, such as magazine titles, new television net- works and Internet sites, generaliy result in losses over an extended development period and are recognized as a reduc- tion of income as incurred, while any corresponding brand value created is not recognized as an intangible asset in the consolidated balance sheet. On the other hand, intangible assets acquired in business combinations accounted for by the purchase method of accounting are capitalized and amor- tized over their expected useful life as a noncash charge against future results of operations. Accordingly, the intangi- ble assets reported in the consolidated balance sheet do not reflect the fair value of Time Warner's internafly generated intangible assets, but rather are limited to intangible assets resulting from certain acquisitions in which the cost of the acquired companies exceeded the fair value of their tangible assets at the time of acquisition. Time Warner amortizes goodwill and sports franchises over periods up to forty years using the straight-line method. Cable television franchises, film and television libraries, music catalogues, contracts and copyrights, and other intangible assets are amortized over periods up to twenty years using the straight-line method. Amo�tization of intangible assets amounted to $800 million in 1998, $912 million in 1997 and $681 million in 1996. Accumulated amortization of intangible assets at December 31, 1998 and 1997 amounted to $3.9 billion and $3.181 billion, respectively. Time Warner periodically reviews the carrying value of acquired intangible assets for each acquired entity to deter- mine whether an impairment may exist. Time Warner consid- ers relevant cash flow and profitability information, including estimated future operating results, trends and other available information, in assessing whether the carrying value of intan- gible assets can be recovered. If it is determined that the carrying value of intangible assets wiil not be recovered from the undiscounted future cash flows of the acquired business, the carrying value of such intangible assets would be consid- ered impaired and reduced by a charge to operations in the amount of the impairment. An impairment charge is mea- sured as any deficiency in the amount of estimated undis- counted future cash flows of the acquired business available to recover the carrying value related to the intangible assets. Income Taxes Income taxes are provided using the liability method prescribed by FASB Statement No. 109, "Accounting for Income Taxes" Under the liability method, deferred income taxes reflect tax carryforwards and the net tax effects of tem- porary differences between the carrying amount of assets and liabilities for financial statement and income tax purposes, as determined under enacted tax laws and rates. The financial effect of changes in tax laws or rates is accounted for in the period of enactment. The subsequent realization of net operat- ing loss and investment tax credit carryforwards acqu�red in acquisitions are accounted for as a reduction of goodwill. The principal operations of the Entertainment Group are conducted by partnerships. Income tax expense includes all income taxes related to Time Warner's allocable share of partnership income and its equity in the income tax expense of corporate subsidiaries of the partnerships. ��r- wn«�:cu i+�� i�ayh nNNU�i RFr�ORr 67 Stock Options In accordance with Accounting Principles Board Opinion No. 25, Accounting for Stock Issued to Employees" ("APB 25"), compensation cost for stock options is recognized in income based on the excess, if any, of the quoted market price of the stock at the grant date of the award or other measurement date over the amount an employee must pay to acquire the stock. Generally, the exercise price for stock options granted to employees equals or exceeds the fair mar- ket value of Time Warner common stock at the date of grant, thereby resulting in no recognition of compensation expense by Time Warner. Loss Per Common Share Effective December 31, 1997, Time Warner adopted FASB Statement No. 128, "Earnings per Share" ("FAS 128"), which established simplified standards for computing and presenting earnings per share information. The adoption of FAS 128 did not have any effect on Time Warner's financial statements. Basic loss per common share is computed by dividing the net loss applicable to common shares after preferred dividend requirements by the weighted average of common shares outs#anding during the pe�iod. Diluted loss per common share adjusts basic loss per common share for the effects of con- vertible securities, stock options and other potentially dilutive financiai instruments, oniy in the periods in which such effect is dilutive. Such effect was not dilutive in any of the periods presented herein. Comprehensive Income Effective January 1, tgg7, Time Warner adopted FASB Statement No. 130, "Reporting Comprehensive Income" ("FAS 130"). The new rules estab- lished standards for the reporting of comprehensive income and its components in financial statements. Comprehensive income consists of net income and other gains and losses affecting shareholders' equity that, under generally accepted accounting principles, are excluded from net income. For Time Warner, such items consist primarily of unrealized gains and losses on marketable equity investments, gains and losses on certain derivative financial instruments and foreign currency translation gains and losses. The adoption of FAS 130 did not have a material eTfect on Time Warner's primary financial 68 �ir,:t wi,�aa[Rir�c i9s�anrwun�kFr>o�� statements, but did affect the presentation of the accompany- ing consolidated statement of shareholders' equity. The following summary sets forth the components of other comprehensive income (loss) accumulated in share- holders' equity: Foreign Accumulated Currenty Derivative Other Unrealized Translation Financial Comprehensive Gains on Gains Instrument Income (miliions) Securities (Losses) Losses (Loss) Balance at December 31, 1997 $ 5 $ (87) $ — $ �82� 1998 activity — 4 (38) (34) _ . Balance at December 31, 1998 $ 5 $(83) $(38) $(1 1 g) Segment Information On December 31, 1997, Time Warner adopted FASB Statement No. 131, "Disclosures about Segments of an Enterprise and Related Information" ("FAS 131 "). The new rules established revised standards for public companies relating to the reporting of financial and descriptive information about their operating segments in financial statements. The adoption of FAS 131 did not have a material effect on Time Warner's primary financial statements, but did affect the disclosure of segment information contained elsewhere herein (Note 16). 2. CABLE TRANSACTIONS In addition to continuing to use cable operating cash flow to finance the level of capital spending necessary to upgrade the technological capability of cable television systems and develop new seroices, Time Warner, TWE and the TWE-Advance/ Newhouse Partnership ("TWE-A/N") completed a series of transactions in 1998. These transactions related to the cable television business and related ancillary businesses that. either reduced existing debt and/or Ti�ne Warner's and TWE's share of future funding requirements for such businesses. These transactions and a cable-related acquisition of Cablevision Industries Corporation and related companies ("CVI") in 1996 are discussed more fully below. TCI Cable Transactions During 1998, Time Warner, TWE, TvVE-A/N and TCI Communications, Inc. ("TCI"), a subsidiary of Tele-Communications, Inc., consummated or agreed to complete a number of cable-related transactions. These transactions con- sisted of (i) the formation in December 1998 of a cable televi- sion joint venture in Texas (the "Texas Cable Joint Venture") that is managed by Time Warner Cable, a division of TWE, and owns cable television systems serving an aggregate 1.1 million sub- scribers, subject to approximately $1.3 billion of debt, (ii) the expansion in August 1998 of an existing joint venture in Kansas City, which is managed by Time Warner Cable, through the contribution by TCI of a contiguous cable television system serving approximately 95,000 subscribers, subject to approxi- mately $200 million of debt and (iii) the agreement to er,change in 1999 various cable television systems serving approximately 575,000 subscribers for other cable television systems of com- parable size in an effort to enhance each company's geographic clusters of cabie television properties (the "TCI Cable Trades"). The Texas and Kansas City joint ventures are being accounted for under the equity method of accounting. As a result of the Texas transaction, the combined debt of Time Warner and TWE was reduced by approximately $650 million. Also; as a result of the Texas and Kansas City transactions, Time Warner and TWE benefited from the geo- graphic clustering of cable television systems and the num- ber of subscribers under the management of Time Warner Cable was increased by approximately 660,000 subscribers. thereby making Time Warner Cable the largest cable television operator in the U.S. The TCI Cable Trades are expected to close periodically throughout 1999 and are subject to custom- ary closing conditions, including ail necessary governmental and regulatory approvals. There can be no assurance that such approvals will be obtained. Time Warner Telecom Reorganization In July 1998, in an effort to combine their business telephony operations into a single entity that is intended to be self-financing, Time Warner, TWE and TWE-A/N completed a reorganization of their busi- ness telephony operations (the "Time Warner Telecom Reorganization") whereby (i) those operations conducted by Time Warner, TWE and TWE-A/N were each contributed to a new holding company named Time Warner Telecom LLC ("Time Warner Telecom"), and then (ii) TWE's and TWE-A/N's interests in Time Warner Telecom were distributed to their partners, Time Warner, MediaOne and the Advance/Newhouse Partnership ("Advance/Newhouse"), a limited partner in TWE-A/I�. As a result of the Time Warner Telecom Reorganization, Ti^;e Warner, MediaOne and Advance/Newhouse own interests in Time Warner Telecom of 61.98%, 18.85% and 19.17%. respectively. Time Warner's interest in Time Warner Teleco^� is being accounted for under the equity method of accountino because of certain approval rights held by MediaOne and Advance/Newhouse. Time Warner Telecom is a competitive locai exchange ca�- rier (CLEC) in selected metropolitan areas across the Unitec States where it offers a wide range of telephony services tc business customers. Following the Time Warner Te�ecom Reorganization, Time Warner Telecom raised approximately $400 million of cash in July 1998 through the issuance o` public notes that mature in 2008. Such notes are non- recourse to Time Warner and the proceeds are be�ng used by Time Warner Telecom to expand and further develop its telephony networks and services. In January 1999. Time Warner Telecom updated a previo�.,_ : filed, preliminary registration statement with the Securities ar- Exchange Commission to conduct an initial public o�fering o= a minority interest of its common stock (the "Time �.varner Telecom IPO"). The Time Warner Telecom IPO was ��evious.: postponed when the IPO market deteriorated anc �=main=_ subject to market 2nd other conditions. There car �e no assurance that it will be completed. Road Runner Joint Venture In June 1998, Time 4Varnec T`,'. _. TWE-A/N, MediaOne, Microsoft Corp. ("Microsoft') znd Corn�z� Computer Corp. ("Compaq") formed a joint venture `o oper�:= and expand Time Warner Cable's and MediaOne's e� sting ^_-- speed online businesses (the "Road Runner Joint \'enture"). In exchange for co�tributing these operations, Time \Varner received a common equity interest in the Road R��ner Joia- Venture of 10.7%. TWE received a 25% interest. ll'dE-A/N received a 32.9% interest and MediaOne received a 31.4�: interest. In exchange for Microsoft and Compaq contributinc $425 million of cash to the Road Runner Joint Ve�-ure, Microsoft and Compao each received a preferred ecu�ty inte�_ _� there�n ti,at is convertible into a 10% common equ:=: interes-. Accordingly, on a fully diluted basis, the Road Runner Joint Venture is owned 8.6% by Time Warner, 20% by T�^.'E. 26.3- : by TWE-A/N, 25.1 �o by MediaOne, 10% by Microsc?t and n�✓f wnrzNEU�r�c i?��t::.•.�._:._ ri-'�'�" " 10% by Compaq. Each of Time Warner's, TWE's and TWE- A/N's interest in the Road Runner Joint Venture is being accounted for under the equity method of accounting. The aggregate $425 million of capital contributed by Microsoft and Compaq is being used by the Road Runner Joint Venture to continue to expand the roll out of high- speed online services. Time Warner Cable has entered into an affiliation agreement with the Road Runner Joint b'enture, pursuant to which Time Warner Cable provides Road Runne�'s high-speed online services to customers in its cable franchise areas through its technologically advanced, high-capacity cable architecture. In exchange, Time Warner Cable initially retains 70% of the subscription revenues anc+ 30% of the national advertising and transactional revenues generated from the delivery of these online services to its cable subscribers. Time Warner Cable's share of these sub- scription revenues will change periodically to 75% by 2006. Primestar In April 1998, TWE and Advance/Newhouse trans- ferred the direct broadcast satellite operations conducted by 11NE and 11NE-A/N (the "DBS Operations") and the 31% part- nership interest in Primestar Partners, L.P. held by TWE-A/N ("Primestar Partners" and collectively, the "�rimestar Assets") to Primestar, Inc. ("Primestar"), a separate holding company. As a result of that transfer and similar transfers by the other previ- ously existing partners of Primestar Partners, Primestar Partners became an indirect wFiolly owned subsidiary of Primestar. In exchange for contributing its interests in the Primestar Assets, TWE received approximately 48 miliion shares of Primestar common stock (representing an approximate 24% equity inter- est) and realized approximately $240 million of debt reduction. In partial consideration for contributing its indirect interest in certain of the Primestar Assets, Advance/Newhouse received an approximate 6% equity interest in Primestar. As a result of this transaction, effective as of April t, 1998, TWE deconsoli- dated the DBS Operations and the 24% equity interest in Primestar received in the transaction is being accounted tor under the equity method of accounting. This transaction is referred to as the "Primestar Roll-up Transaction" In connection with the Primestar Roll-up Transaction, Primestar and Primestar Partners own and operate the medium-power direct broadcast satellite business, portions of which were formerly owned by TCI Satellite Entertainment, Inc. ("TSAT") and the other previously existing partners of Primestar Partners. Certain high-power system assets; %O TIM[ wARNf:R INC 1998 ANNUAL REPOkI including two high-power satellites, continue to be owned by Tempo Satellite, Inc. ("Tempo"), a whol�y owned subsidiary of TSAT. However, Primestar Partners has an option to lease or purchase the entire capacity of the high-power system from Tempo. In addition, Primestar has an option to purchase the stock or assets of Tempo from TSAT. In a related transaction, Primestar Partners also entered into an agreement in June 1997 with The News Corporation Limited ("News Corp."), MCI WorldCom, Inc. ("MCI") and American Sky Broadcasting LLC ("ASky6"), pursuant to which Primestar would acquire certain assets relating to the high-power, direct broadcast satellite business of ASkyB (the "Primestar ASky6 Transaction"). In May 1998, the U.S. Department of Justice brought a civil action against Primestar, each of its cable owners, including TWE, and News Corp. and MCI, to enjoin on antitrust grounds the Primestar ASkyB Transaction. Although the parties had discussions with the U.S. Department of Justice in an attempt to restructure the transac- tion, no resolution was reached and the parties terminated their agreement in October 1998. In the fourth quarter of 1998, TWE recorded a charge of approximately $210 million principally to reduce the carrying value of its interest in Primestar. This charge refiected a sig- nificant decline in the fair value of Primestar during the quarter and has been included.in interest and other, net, in T1NE's 1998 consolidated statement of operations. In addition, Primestar, Primestar Partners and the stock- holders of Primestar have entered into an agreement to sell the medium-power direct broadcast satellite business and assets to DirecN, a competitor of Primestar owned by Hughes Electronics Corp. Also, Primestar, Primestar Partners, the stockholders of Primestar and Tempo entered into a sec- ond agreement with DirecTV, pursuant to which DirecTV will purchase the high-power satellites from Tempo, and Primestar and Primestar Partners will relinquish their respective rights to acquire or use such high-power satellites. The price to be paid by DirecN pursuant to these agreements confirmed the decline in value of TWE's interest in Primestar. The ulti- mate disposition of the medium-power assets of Primestar is subject to Primestar bondholder and regulatory approvals, and the disposition of certain of the high-power satellite rights is also subject to regulatory approvals. Accordingly, there can be no assurance that such approvals will be obtained and that these transactions will be consummated. TWE-A/N Transfers As of December 31, 1998, TWE-A/N owned cable television systems (or interests therein) serving approximately 6.3 million subscribers, of which 5.2 million subscribers were served by consolidated, wholly owned cable television systems and 1.1 million subscribers were served by unconsolidated, partialiy owned cable television systems. TWE-A/N had approximately $1.2 billion of debt at Decem- ber 31, 1998. TWE-A/N is owned approximately 64.8Mo by TWE, the managing partner, 33.3% by Advance/Newhouse and 1.9% indirectly by Time Warner. TWE consolidates the partnership, and the partnership interests owned by Advance/Newhouse and Time Warner are reflected in TWE's consolidated financial statements as minority interest In accordance with the part- nership agreement, Advance/Newhouse can require TWE to purchase its equity interest for fair market value at specified intervals following the death of both of its principal sharehold- ers. In addition, TWE or Advance/Newhouse can initiate a restructuring of the partnership, in which Advance/Newhouse would withdraw from the partnership and receive one-third o# the partnership's net assets. In early 1998, Time Warner (through a wholly owned subsidiary) contributed cable television systems (or interests therein) serving approximately 650,000 subscribers to TWE-A/N, subject to approximately $1 billion of debt, in exchange for common and preferred partnership interests in TWE-A/N, and completed certain related transactions (collectively, the "TWE-A/N Transfers"). The cable television systems transferred to TWE-A/N were formerly owned by TWI Cable Inc. ("TWI Cable"), a wholly owned subsidiary of Time Warner, and Paragon Communications ("Paragon"), a partnership formeriy owning cable television systems serving approximately 1 million subscribers that was wholly owned by subsidiaries of Time Warner, with 50% beneficially owned in the aggregate by TWE and TWE-A/N. The debt assumed by TWE-A/N has been guaranteed by TWI Cable and certain of its subsidiaries, including Paragon. As part of the TWE-A/N Transfers, TWE and TWE-A/N exchanged substantially all of their respective beneficial interests in Paragon for an equivalent share of Paragon's cable television systems (or interests therein) serving approximately 500,000 subscribers, resulting in wholly owned subsidiaries of Time Warner owning 100% of the restructured Paragon entity, with less than 1% beneficially held for TWE. Accordingly, effective as of January 1, 1998, Time Warner has consu� iated Paragon. Because this tran- saction represented an exchange of TWE's and TWE-A/N's beneficial interests in Paragon for an equivalent amount of its cable television systems, it did not have a significant eco- nomic impact on Time Warner, TWE or TWE-A/N. The TWE-A/N Transfers were accounted for effective as of January 1, 1998. Time Warner did not recognize.a gain or loss on the TWE-A/N Transfers. TWE has continued to con- solidate TWE-A/N and Time Warner has accounted for its interest in TWE-A/N under the equity method of accounting. On a pro forma basis, giving effect to the TWE-A/N Transfers as if they had o�curred at the beginning of 1997, Time Warner would have reported for the year ended December 31, 1997 revenues of $13.233 billion, depreciation expense of $375 million, operating income before noncash amortization of intangible assets of $2.068 billion, operating income of $1.219 billion, equity in the preta�c income of the Entertainment Group of $679 million, income before extraord;- nary item of $307 million ($.01 loss per common share) and net income of $252 million ($.06 loss per common share). CVI Acquisition On January 4, 1996, Time Warner acquired CVI, which owned cable television systems serving approxi- matety 1.3 million subscribers, in exchange for the issuance of approximately 5.8 million shares of common stock and approximately 6.3 million shares of new convertible preferrec stock ("Series E Preferred Stock" and "Series F Preferred Stock") and the assumption or incurrence of approximately $2 billion of indebtedness. The acquisition was accounted ror by the purchase method of accounting for business combin2- tions; accordingly, the cost to acquire CVI of $904 million was ailocated to the net assets acquired in proportion to the � respective fair values, as follows: cable television franchises- $2.390 billion; goodwill-$688 million; other current and no^- current assets-$481 million; long-term debt-$1.766 billion; deferred income taxes-$731 million; and other current and noncurrent liabilities-$158 million. In October 1996, Time Warner reorganized the legal o�vn- ership of its wholly owned cable subsidiaries, whereby the equity ownership of its other wholly owned cable subsidiar�es was contributed to CVI. In connection therewith, CVI was renamed TWI Cable Inc. 7:MC WAf1nCH IN(; 1498 ��':'..%+l RE�f��' %� a TBS TRANSACTION On October 10, 1996, Time Warner acquired the remaining 80% interest in TBS that it did not already own (the "TBS Transaction"). As part of the transaction, each of TW Companies and TBS became a separate, wholly owned sub- sidiary of Time Warner which combines, for financial report- ing purposes, the consolidated net assets and operating results of TW Companies and TBS. Each issued and out- standing share of each class of capital stock of 7W Companies was converted into one share of a substantially identical class of capital stock of Time Warner. in connection with the TBS Transaction, Time Warner issued (i) approximately 359.6 million shares of common stock (including 1 14.2 million equivalent shares of common stock in the form of a special class of non-redeemable com- mon stock ("Series LMCN-V Common Stock") to affiliates of Liberty Media Corporation ("LMC"), a subsidiary of Tele- Communications; Inc.), in exchange for shares of TBS capi- tal stock and pursuant to a separate option agreement with LMC and its affiliates (the "SSSI Option Agreement") and (ii) approximately 28 million stock options to replace all outsfanding TBS stock options. Time Warner alsb assumed approximately $2:8 billion of indebtedness. - Of the aggregate consideration issued in fhe TBS Trans- action; 12.8 miliion equivalant shares of common stock in the form of Series LNaCN-V Common Stock were issued to LMC and its affiliates in June 1997 pursuant to the SSSI Option Agreement. The SSSI Option Agreement enabled Time Warner to acquire substantially all of the assets of Southern Satellite Systems, Inc. and its affifiates ("SSSI"), a subsidiary of LMC that formerly provided uplink and distribution ser- vices for WTBS (the "TBS Superstation"), for approximately $213 miliion effective as of December 31, 1997, the date on which the TBS Superstation was converted to a copyright- paid, cable television programming service. The TBS Transaction was accounted for by the purchase method of accounting for business combinations; accord- ingly, the cost to acquire TBS of approximately $6.2 billion was allocated to the net assets acquired in proportion to their respective fair values, as follows: goodwill-$6.842 b�l- lion; other current and noncurrent assets-$3.624 billion: long-term debt-$2.765 biilion; deferred income taxes- $1 17 million; and other current and noncurrent liabilities- $1.410 billion. 72 in.�r i•n�urir v; r•ic �5, -.�: �ai kFi>o�� 4. ENTERTAINMENT GROUP Time Warner's investment in and amounts due to and from the Entertainment Group at December 31, 1998 and 1997 consists of the following: December 31, (millions) 199B 1997 Investment in TWE $ 3,850 $ 5,577 Stock option related distributions due from TWE ��30 4�7 Credit agreement debt due to TWE (400) (400) Other net amounts due to TWE, principally related to home video distribution (395) (�41� .... ... nvestment in and amounts due to and from TWE 4,185 5,453 Investment in TWE-A/N and other Entertainment Group companies 795 gg _ ..._ Total $ 4,980 $ 5,549 Partnership Structure TWE is a Delaware limited partnership that was capitalized on June 30, 1992 to own and operate sub- stantially all of the Filmed Entertainment-Wamer Bros., Cable Networks-HBO and Cable businesses previously owned by sub- sidiaries of Time Warner. Certain Time Warner subsidiaries are the general partners of TWE ("Time Warner Generaf Partners`). Time Warner, through its wholly owned subsidiaries, collec- tively owns generai and limited partnership interests in TWE consisting of 74.49% of the Series A Capital and Residual Capital and 100% of the Senior Capital and Series B Capital. The remaining 25.51% limited partnership interests in the Series A Capital and Residual Capital of TWE are owned by MediaOne, which acquired such interests in 1993 for $1.532 bil- iion of cash and a$1.021 billion 4.4% note (the "MediaOne Note Receivable") that was fully collected during 1 gg6. Partnership Capital and Allocation of Income Each partner's interest in 11NE generally consists of the undistributed prioriiy capitai and residual equity amounts that were initially assigned to that partner or its predecessor based on the estimated fair vaiue of the net assets each contributed to TWE (�'Undistributed Contributed Capital"), plus, with respect to the priority capitai interests only, any undistributed priority capital return. The prior- ity capital retum consists of net partnership income allocated to date in accordance with the provisions of the TWE partnership agreement and the right to be allocated additional partnership income which, together, provides for the various priority capital rates of return as specified in the table below. The sum of Undistributed Contributed Capital and the undistributed priority capital return is referred to herein as `Cumulative Priority Capital" Cumulative Priority Capital is not necessarily indicative of the fair value of the underlying priority capital interests principally due to above-market rates of return on certain priority capital interests as compared to securities of compara- ble credit risk and maturity, such as the 13.25% rate of return on the Series B Capital interest owned by the Time Warner General Partners. Furthermore, the ultimate realization of Cumulative Priority Capital could be affected by the fair value of TWE, which is subject to fluctuation. A summary of the priority of Undistributed Contributed Capital, Time Warner's ownership of Undistributed Contributed Capital and Cumulative Priority Capital at December 31, 1998 and priority capitai rates of return thereon is as set forth below: Prioriiy of Undistributed Cumulative Priority Undistributed Contributed Prioriiy Capital Contributed Capital�a> Capital Rates of �/o Owned by Capital . (billions) (billions) Return�b� Time Warner Senior Capital $ 0.5 $ 0.6 8.00% 100.00% Series A Capital 5.6 12.8 13.00% 74.49% Series B Capital 2.9�d� 6.8 13.25�/o 100.00a/o Residual Capital 3.3�d> 3.3<<> —<<� 74.49% (a) Eadudes partnership income or loss allocated thereto. (b) To the extent income allocations are concurrently distr�buted, the priority capital � rates of return on the Series A Capital and Series B Capital are 1 1 Wo and 1 1.25%, respectively. (c) Residual Capital is not entitled to stated priority rates of return and, as such, its Cumulative Priority Capital is equal to its Und�stributed Contributed Capdal. However, in the case of certain events such as the liqwdation or d�ssolution of TWE, Residual Capital Is e�t�tled ;o any ezcess of the then ta�r value of the net assets of TVJE over the aggregate amount of Cumulative Prionty Cap�tat and special tax allocations. (d) Th,e Undistributed Contnbuted Cap�tal relating to the Series B Capdal has pnonty over the priority returns on the Series A CapitaL The Und�stnbuted CoMnbuted Capital relabng to the Res�dual Capital has priority over the prwnty retums on the Series B Capital and the Series A Capitai. Because Undistributed Contributed Capital is generally based on the fair value of the net assets that each partner initially contributed to the partnership, the aggregate of such amounts is significantly higher than TWE's partners' capital as reflected in the consolidated financial statements, which is based on the historical cost of the contributed net assets. For purposes of allocating partnership income or loss to the partners, partnership income or loss is based on the fair r,��ue of the net assets contributed to the partnership and results in significantly less partnership income, or results in partnership losses, in contrast to the net income reported by TWE for financial statement purposes, which is also based on the historical cost of contributed net assets. Under the NVE partnership agreement, partnership income, to the extent earned, is first allocated to the part- ners' capital accounts so that the economic burden of the income tax consequences of partnership operations is borne as though the partnership were taxed as a corporation ("spe- cial tax allocations"). After any special tax allocations, part- riership income is allocated to the Senior Capital, Series A Capital and Series B Capital, in order of priority, at rates of return ranging from 8% to 13.25% per annum, and finally to the Residual Capital. Partnership losses generally are allo- cated first to eliminate prior allocations of partnership income to, and then to reduce the Undistributed Contributed Capital of, the Residual Capital, Series B Capital and Series A Capital, in that order, then to reduce the Time Warner General Partners' Senior Capital, including partnership income allocated thereto, and finally to reduce any sPecial. tax allocations. To the extent pa�tnership income is insufficient to satisfy all special allocations in a particular accounting period, the right to receive additional partnership income necessary to provide for the various priority capital rates of return is carried forward until satisfied out of future partnership income, including any partnership income tha! may result from any liquidation, sale or dissolution of TWE. TWE reported net income of $326 million, $614 million and $210 million in 1998, 1997 and 1996, respectively, no por- tion of which was allocated to the limited partners. The Series B Capital owned by the Time Warner General Partners may be increased if certain operating performance targets are achieved over a ten-year period ending on December 31, 2001, although it does not appear likely at this time that such targets will be achieved. In addition, MediaOne has an option to obtain up to an additional 6.33°,'0 of Senes A Capital and Residuai Capital interests, depending on cable operating performance. The option is exercisable at any time through May 2005 at a maximum exercise price of $1.25 billion to $1.8 billion, depending on the year of exer- cise. Either MediaOne or TWE may elect that the exercise price be paid with partnership interests rather than cash. ;��.E �v,;nwEF wc i99ft nn�iau.::, r,_ �C?t 73 Summarized Financial Information of the Entertainment Grc,� p Set forth below is summarized financiai information of the Entertainment Group, which reflects the TWE-A/N Transfers effective as of January 1, 1998, the Primestar Roll-up Transaction effective as of April 1, 1998, the formation of the Road Runner Joint Venture effective as of June 30, 1998 and the Time Warner Telecom Reorganization effective as of July 1, 1998. Years Ended December 31, (miliions) 1998 1gg7 lggg Operating Statement Information Revenues $12,256 $11,328 $10,86t Depreciation and amortization (1,436) (1,386) (t,244; Business segment operating income�� 1,724 1,461 1,090 Interest and other, net�2� (965) (357) (524) Minority interest (264) (305) (2p7) Income before income taxes 423 727 2gp Income before extraordinary item 331 gq2 22� Net income 331 619 220 (! ) Includes net pretaz gains oF approzimately $90 million in 1998 and $200 million in 1997 related to the sale or exchange of certain cable television systems. (2) Includes a charge of approximately 5210 million in 199$ principally to reduce the carrying value of an interest in Primestar. 1997 includes a gain of approxi- mately $250 million related to the sale of an interest in E! EnteRainment Television, Inc. CE! Entertainment"). %Q 7ln�i- �•.,.,..,_� �\� 149H,�Nf�UAI HF4'()Hl Years Ended December 31, (millions) 1998 Cash Flow Information Cash provided by operations Capital expenditures Investments and acquisitions investment proceeds Borrowings Debt repayments Issuance of preferred stock of subsidiary Collections on note receivable from MediaOne Capital distributions Other financing activities, net increase (decrease) in cash and equivalents December 31, (millions) Balance Sheet Information Cash and equivaients Total current assets Total assets Total current liabilities Long-term debt Minority interests Preferred stock of subsidiary Time Warner General Partners' Senior Capital Partners' ca�ital 1997 1996 $2,288 $ 1,799 $ 1,912 (1,603) (1,565) (1,719) (388) (172) 1,246 520 1,514 3,400 (1,898) (3,085) — 243 (1,153) (934) (241) (100) (235) 106 1998 $ 87 4,187 22,241 4,940 6,578 1,522 217 (146) 612 215 (716) 169 (228) (92) 7 1997 $ 322 3.623 20.739 3,976 5.990 1.210 233 603 1.118 5,210 6.430 Capital Distributions The assets and cash flows of TWE are restricted by the TWE partnership and credit agreements and are unavailable for use by the partners except through the payment of certain fees, reimbursements, cash distributions and loans, which are subject to limitations. The Time Warner General Partners received $579 million and $535 million in 1998 and 1997, respectively, of distri- butions from TWE relating to their Senior Capital interests. thereby increasing the cumulative cash distributions received from TWE on such interests to $1.5 billion. The Time Warner General Partners' remaining $603 mil��on Senior Capital interests and any undistributed partnership income allocated thereto (based on an 8°k annual rate of return) are required to be distributed on July 1, 1999. At December 31, 1998 and 1997, the Time Warner General Partners had recorded $1.130 billion and $417 mil- lion, respectively, of stock option related distributions due from TWE, based on closing prices of Time Warner common stock of $62.06 and $31.00, respectively. Time Warner is paid when the options are exercised. The Time Warner General Partners also receive tax-related distributions from TWE on a current basis. During 199�,, the Time Warner General Partners received distributions from TWE in the amount of $1.153 billion, consisting of $579 million of Senior Capital distributions (representing the return of $455 million of contributed capital and the distribution of $124 million of priority capital return), $314 million of tax- related distributions and $260 million of stock option related distributions. During 1997, the Time Warner General Partners received distributions from TWE in the amount of $934 mil- lion, consisting of $535 million of Senior Capital distributions (representing the return of $455 million of contributed capital and the distribution of $80 million of prioritycapital retum),.$324 million of tax-related distributions and $75 million of stock option related distribution,. During 1996, the Time Warner General Partners received distributions from TWE in the amount of $228 million, consisting of $215 million of tax-related distributions and $13 million of stock option related distributions. In addition to the tax, stock option and Time Warner General Partners' Senior Capital distributions, TWE may make other capital distributions to its partners that are also subject to certain Iimitations contained in the TWE partnership and credit agreements. In addition, in connection with the Time Warner Telecom Reorganization, TWE made a$191 million noncash distribu- tion to its partners, of which certain wholly owned subsidiaries of Time Warner received an interest in Time Warner Telecom recorded at $143 million based on TWE's historical cost of the net assets (Note 2). Debt Guarantees Each Time Warner General Partner has guaranteed a pro rata portion of approximately $5.5 billion of TWE's debt and accrued interest at December 31, 1998, based on the relative fair value of the net assets each Time Warner General Partner (or its predecessor) contributed to TWE. Such indebtedness is recourse to each Time Warner General Partner only to the extent of its guarantee. There are no restrictions on the ability of the Time Warner General Partner guarantors to transfer assets, other than TWE assets, to parties that are not guarantors. In addi!ion, in connection with the TWE-A/N Transfers (Note 2), approximately $1.2 billion of TWE-A/N's debt and accrued interest at December 31, 1998 has been guaranteed by TWI Cable and certain of its subsidiaries. Six Flags In April 1998, NVE sold its remaining 49% interest in Six Flags Entertainment Corporation ("Six Flags") to Premier Parks Inc. ("Premier"), a regional theme park operator, for approximately $475 million of cash. TWE used the net, after-tax proceeds from this transaction to reduce debt by approximately $300 million. As part of the transaction, TWE will continue to license its animated cartoon and comic book characters to Six Flags's theme parks and will similarly license such rights to Premier's theme parks in the United States and Canada under a long-term agreement covering an aggregate of twenty-five existing and all future locations. A substantial portion of the gain on this transaction has been deferred by TWE, principall� zs a result of uncertainties surround.ing realization that relate to ongoing litigation and TYVE's continuing guarantees of certain significant long-term obligations associated with the Six Flags Over Texas and Six Flags Over Georgia theme parks. 5. OTHER INVESTMENTS Time Warner's other investments consist of: Decemoer 31, (milGons) 1998 '997 Equity method investments $483 S �.350 Cost and fair-value method investments 311 t 45 _. . . Total $ 794 S ; .495 In addition to TWE and its equity investees, compan�es accounted for using the equity method include: Time Warner Telecom (62% owned), the Columbia House Company oart- nerships (50% owned), other music joint ventures (generally 50% owned) and Cinamerica Theatres, L.P. (sold in 1997. TIMC WAHNLR INC 1998 ANNUAL n��K- %S but previously 50a/o owned). A summary of combined finan- cial information as reported by the equity investees of Time Warner is set forth below: Years Ended December 31, (millions) 1998 1997 1996 Revenues $1,275 $1,336 $1,773 Depreciation and amortization (43) (13) (29) Operating income (loss) (1) 80 173 Net income (loss) (109) (36) 61 Current assets 1,183 792 1,002 Total assets 2,065 1,132 1,616 Currentliabilities 5g� q�g 5�� Long-term debt 1,807 1,303 1,360 Totalliabilities 2,464 1,791 t,ggg Total shareholders' deficit or partners' capital (399) (659) (383) In addition to the equity investees listed above, TWE's equity investees at December 31, 1998 included: Comedy Partners, L.P. (50% owned), certain cable television system joint ventures (generally 50% owned), the Road Runner Joint Venture (57.9% owned, excluding Time Warner's direct 10.7% interest), Primestar (24�/o owned), Six Flags (49% owned in 1997 and 1996), certain international cable and programming joint ventures (25% to 50% owned) and Courtroom Television Network (50% owned). A summarX of combined financial information as reported by the equity investees of TWE is set forth below: Years Ended December 31, (millions) 1998 tgg7 Revenues $ 2,32g $ 2,2p� Depreciation and amortization (706) (235) Operating income (loss) (265) t � 8 Net loss (352) (82) (138) Current assets 665 412 624 Total assets 5,228 3,046 Current liabilities 628 993 Long-term debt 2,917 �,625 Totalliabilities 3,699 2,734 Total shareholders' equity or partners' capital 1,529 312 1996 $1,823 (197) 62 %6 1'�`,•,� WARNER INC' 1yQtl ANNUAL REPpRI 3,193 407 2,197 2,829 364 Included in the foregoing summary is combined financial information of Time WarnE, Cable's unconsolidated cable television systems that serve an aggregate of 2.3 million sub- scribers as of December 31, 1998. Time Warner Cable has an approximate 50% weighted-average interest in these cable television systems. For 1998, excluding the operating results of the Texas Cable Joint Venture which was formed at the end of the year, these cable television systems reported combined operating income of $93 million and combined depreciation and amortization of $160 miilion. Similarly, at the end of 1998, including approximately $1.3 billion of debt of the Texas Cable Joint Venture, these cable television sys- tems had debt of approxir�ately $2.4 billion. 6. INVENTORIES Inventories consist of: 1998 1997 December 31, (millions) Current Noncurrent Current Noncurrent Film costs: Released, less amortization $ 51 $ 308 $ 68 $ 22g Completed and not released 20 — gg qg In process and other 2 24p — �q� Library, less amortization — 1,007 — 1,064 Programming costs, less amortization 457 345 293 285 Magazines, books and recorded music 416 — 381 _ _. Total $ 946 $1,900 $ 830 $1,766 Excluding the Library, the total cost incurred in the pro- duction of theatrical and television product (including direct production costs. production overhead and certain exploitation costs, such as film prints and home videocassettes) amounted to $633 million ;n 1998 and $506 million in 1997; and the total cost amortized amounted to $585 million and $613 mil- lion, respectivel�. Excluding the Library, the unamortized cost of completed films at December 31, 1998 amounted to $379 million. approximately 90% of which is expected to be amortized within three years after release. 7. LONG-TERM DEBT Long-term debt consists of: Weighted-Average Interest Rate at December 31, December 31, 1998 Maturities 1998 1997 Bank credit (millions) agreement borrowings 6.0% 2002 $ 1,234 $ 2,600 Fixed-rate senior notes and debentures 7.8% 2000-2036 8,491 6,909 Variable- � ate senior notes 4.8�/a 2009-2031 1,200 t,200 Zero-coupon convertible notes — — — 1,124 _ .. ... ... ..... . _.. .. .... . ... . ... ....._.._...... _ _....._..........................._ .. ....... ........_.. Total $10,925 $ t 1,833 Substantially all of Time Warner's long-term debt repre- sents the obligations of its wholiy owned subsidiaries TW Companies, TBS and TWI Cable. Time Warner and each of TW Companies and TBS (the "Guarantor Subsidiaries") have fully and unconditionally guaranteed any outstanding publicly traded indebtedness of each other and, along with TWI Cable, have similarly guaranteed each others outstanding borrowings under their joint bank credit agreement. As a result, the credit profile associated with the indebtedness of Time Warner or any of the Guarantor Subsidiaries is substan- tially the same. Financing Activities During the past three years, in response to favorable market conditions and in connection with certain acquisitions, Time Warner and its consolidated subsidiaries have refinanced approximately $8.5 billion of debt. These debt refinancings have had the positive effect of lowering the Company's cost of borrowing, staggering debt maturities and, with respect to the redemption of certain convertible securi- ties, eliminating the potentiai dilution from the conversion of such securities into 62.5 million shares of Time Warner com- mon stock. In connection with these refinancings, Time Warner recognized an extraordinary loss on the retirement of debt of $55 million in 1997 and $35 million in 1996. In addition to these refinancings, Time Warner continued its debt reduction efforts in 1998. Debt reduction of approxi- mately $3 billion was partially offset by a$2.1 biilion increase in debt in order to fund the 1998 redemption of Time Warner's Series M Preferred Stock (Note 1 1). This debt reduction was achieved principally by using cash provided by operations, pro- ceeds from certain asset sales, cash distributions from TW� and the noncash transfer of approximately $1 biliion of debt to TWE-A/N as part of the TWE-A/N Transfers (Note 2). Zero-Coupon Convertible Notes During 1998, approximately $1.15 billion accreted amount of zero-coupon convertible notes due 2013 (the "Zero-Coupon Convertible Notes") were con- verted into an aggregate 37.4 million shares of Time Warner common stock. To partially offset the dilution resulting from this conversion, Time Warner incurred a corresponding $1.15 billion of debt and used the proceeds therefrom to repurchase com- mon stock (Note 12). Variable-Rate Notes At December 31, 1998, variable-rate senior notes consisted of $600 million principal amount of Floating Rate Reset Notes due July 29, 2009 that are redeemable at the election of the holders, in whole but not in pa�, on July 29, 1999 (the "Two Year Floating Rate Notes") and $600 million principal amount of Floating Rate Reset Notes due December 30, 2031 that are similarly redeemable at the elec- tion of the holders on December 30, 2001 (the "Five-Year Floating Rate Notes"). The Two-Year Floating Rate Notes bear interest at a floating rate equal to LIBOR less 1 15 basis points until July 29, 1999, at which time, if not redeemed, the interest rate will be reset at a fixed rate equal to 6.16% plus a margin based upon the credit risk of TW Companies at such time. The Five-Year Fioating Rate Notes bear interest at a floating rate equal to LIBOR less 25 basis points until December 30, 2001. at which time. if not redeemed, the interest rate will be reset at a fixed rate equal to 6.59% plus a margin based upon the credit risk of TW Companies at such time. Bank Credit Agreement As part of the debt refinancings referred to above, Time Warner, together with certain of its con- solidated and unconsolidated subsidiaries, entered into a five- year revolving credit facility in November 199� (the'1997 Credit Agreement") and terminated its subsidiaries' financing arrangements under certain previously existing bank credit facili- ties (the "Old Credit Agreements"). This enabled Time Warner to reduce its aggregate borrowing availability from $10.3 billion to $7.5 billion, lower interest rates and refinance outstanding borrowings under the Old Credit Agreements in the amounts of approximately $2.4 billion by subsidiaries of Time Warner and $2.1 billion by TWE. IiME WAFNfF IfvC 1t1`.lM /.r_I:,�.;� ��0�7 %% The 1997 Credit Agreement permits borrowings in an aggregate amount of up to $7.5 billion, with no scheduled reduction in credit availability prior to maturity in November 2002. The borrowers under the 1997 Credit Agreement are Time Warner, TW Companies, TBS, TWI Cable, TWE and TWE-A/N. Borrowings under the 1997 Credit Agreement are limited to (i) $6 billion in the aggregate for Time Warner, TW Companies, TBS and TWI Cable, (ii) $7.5 billion in the case of TWE and (iii) $2 billion in the case of TWE-A/N, subject in each case to an aggregate borrowing limit of $7.5 billion and certain other limitations and adjustments. Such borrow- ings bear interest at specific rates for each of the borrowers (generally equal to LIBOR plus a margin initially ranging from 35 to 40 basis points) and each borrower is required to pay a commitment fee on the unused portion of its commitment (initially ranging from .125% to .15% per annum), which mar- gin and fee vary based on the credit rating or financial lever- age of the applicable borrower. Borrowings may be used for general business purposes and unused credit is available to support commercial paper borrowings. The 1997 Credit Agreement contains cehain covenants generally for each borrower relating to, among other things, additional indebted- ness; liens on assets; cash flow coverage and leverage ratios; and dividends, distributions and other restricted. cash pay- ments or transfers of assets from the borrowers to their respective shareholders; partners or affiliates. Credit Agreement with TWE Time Warner has a credit agreement with TWE that allows it to borrow up to $400 million from TWE through September 15, 2000. Outstanding bor- rowings from TWE in the amount of $400 million bear interest at LIBOR plus 1% per annum. All amounts due to TWE under this agreement have been reclassified to Time Warner's invest- ment in and amounts due to and from the Entertainment Group in the accompanying consolidated balance sheet %B 71MF WAR�'fR I�� 194Ei ANNU�L REPCIRT Interest Expense and Maturities At December 31, 1998, Time Warner had interest rate swap contracts to pay floating- rates of interest and receive fixed-rates of interest on $1.6 bil- lion notional amount of indebtedness, which resulted in approximately 37% of Time Warner's underlying debt being subject to variable interest rates (Note 15). Interest expense amounted to $891 million in 1998, $1.049 billion in 1997 and $968 million in 1996, including $6 million in 1998, $19 million in 1997 and $26 million in 1996 which was paid to TWE in connection with borrowings under Time Warner's $400 million credit agreement with TWE. The weighted-average interest rate on Time Warner's total debt, including the effect of interest rate swap con- tracts, was 7.2% at December 31, 1998 and 1997. Annual repayments of long-term debt for the five years subsequent to December 31, 1998 consist of $500 million due in 2000, and $1.234 biilion due in 2002. Such repayments exciude the aggregate redemption prices of $600 million in 1999 and $600 million in 2001 relating to the variable-rate senior notes, in the years in which the holders thereof may first exercise their redemption options. Fair Value of Debt Based on the level of interest rates pre- vailing at December 31, 1998 and 1997, the fair value of Time Warner's fixed-rate debt exceeded its carrying value by $1.098 billion and $753 million; respectively. Unrealized gains or losses on debt do not result in the realization or expenditure of cash and generally are not recognized for financial reporting purposes unless the debt is retired prior to its maturity. 8. BORROWINGS AGAINST FUTURE STOCK OPTION PROCEEDS In 1998, in connection with Time Warner's expanded com- mon stock repurchase program (Note 12), Time Warner entered into a new five-year, $1.3 billion revo�ving credit facility (the "Stock Option Proceeds Credit Facility"), which replaced its previously existing facility. Borrowings under the Stock Option Proceeds Credit Facility are principaliy used to fund stock repurchases and approximately $12 million of future preferred dividend requirements on Time Warner's convertible preferred stock as of December 31, 1998. At December 31, 1998 and 1997, Time Warner had outstand- ing borrowings against future stock option proceeds of $895 million and $533 million, respectively. The Stock Option Proceeds Credit Facility initially provides for borrowings of up to $1.3 billion, of which up to $125 million is reserved solely for the payment of interest and fees there- undec Borrowings under the Stock Option Proceeds Credit Facility generally bear interest at LIBOR plus a margin equal to 75 basis points and are principally expected to be repaid from the cash proceeds received from the exercise of desig- nated employee stock options. The receipt of such stock option proceeds in excess of $900 million through March 2000, and thereafter in full on a cumulative basis, permanently reduces the borrowing availability under the facility. At December 31, 1998, based on a ciosing market price of Time Warner common stock of $62.06, the aggregate value of potential proceeds to Time Warner from the exercise of out- standing vested, °in the money" stock options covered under the facility was approximately $1.9 billion, representing a 1.5 to 1 coverage ratio over the related $1.3 biliion borrowing availability. To the extent that such stock option proceeds are not sufficient to satisfy Time Warner's obligations under the Stock Option Proceeds Credit Facility, Time Warner is generally required to repay such borrowings using proceeds from the sale of shares of its common stock heid in escrow under the Stock Option Proceeds Credit Facility or, at Time Warner's election, using available cash on hand. Time Warner had placed 76 million shares in escrow at December 31, 1998, which shares are not considered to be issued and outstanding capital stock of the Company. Time Warner may be required, from time to time, to have up to 210 million shares held in escrow. In addition, as a result of Time War��ers commitment to use the Stock Option Proceeds Credit Facility to fund future preferred dividend requirements on certain classes of its convertible pre- ferred stock, Time Warner has also supplementally agreed to place in escrow an amount of cash equal to any excess of the unpaid, future preferred dividend requirements on such series of convertible preferred stock over the borrowing availability under the facility at any time. 9. INCOME TAXES Domestic and foreign pretax income (loss) are as follows: Years Ended December 31, (millions) 1998 1997 1996 Domestic $ 486 $ 728 � (193) Foreign 100 104 197 .._ . _..... _....__. . Total $ 586 $ 832 S a Current and deterred income taxes (tax benefits) provided are as follows: Years Ended December 31, (m�ll�ons) 1998 1997 �996 Federal: Current�'> $ 436 $ 191 S 50 Deferred (259) 49 i , a3) Foreign: Current�2> 260 205 230 Deferred (49) (3) ( � 6) State and Local: Current��> 166 88 6� Deferred (136) 1 (50) Total $ 418 $ 531 S' 00 (1) Includes ut �,za;�on of tax carryforwards of $126 million in 1998, $10? ^' _ � 1997 and S77 m�l6on �n 1996. Excludes current federal and state anc �___ ._ beneiits o' S478 million in 1998, $165 million in 1997 and $20 miltion r' S95 �esulGng `roT, the exercise of stock opbons and vesGng of restricted s:.:•� awards, wh�cn v�ere credited d�rectly to paid-�n-capital. Excludes cu�re^� �5_e�a tax benchts a� 530 mdlion in 1997 and $4 million in 1996 resulhng .`rC .- ret�remen; o` ce�;. wn�ch reduced the eKtraord�nary losses �n such �ea•, (2) Includes fo•e•cn �-ithhold�ng taxes of 51 13 mtlhon in 1998. 51 14 m��l'�_- - 1997 and 51 C 1 mdhon in 1996. ��i�i �.. . .. a iNC ,�i�::� .�n��:�.�.:� _. - . 79 The differences between income taxes expected at the U.S. federal statutory income tax rate ot ,;5% and income taxes provided are as set forth below. The relationship between income before income taxes and income tax expense is most affected by the amortization of goodwill and certain other financial statement expenses that are not deductible for income tax purposes. Years Ended December 31, (millions) Taxes on income at U.S. federal statutory rate State and local taxes, net of federal tax benefits Nondeductible goodwill amortization Other nondeductible expenses Foreign income taxed at different rates, net of U.S. foreign tax credits 0#her : __.... .....,_...... Totai 1998 1997 1996 $ 205 $ 291 $ 2 20 58 26 170 170 131 13 t 1 10 — 9 4 10 (8) (13) _......,.... _... _.._ _.. $418 $531 $160 Significant components of Time Wamer's net deferred tax liabilities are as follows: December 31, (millions) Assets acquired in business combinations Depreciation and amortization Unrealized appreciation of certain marketable securities Other Deferred tax liabilities Tax carryforwards Accrued liabilities Receivable alluwances and return reserves Other Deferred tax assets Net deferred tax liabilities 80 tinnL w:�n^,dLR in�: ��uyg q�vrcun� aE�ORi 1998 --_-1997 U.S. income and foreign withholding taxes have not been recorded on permanently reinvested earnings of foreign subsidiaries aggregating approximately $945 million at December 31, 1998, Determination of the amount of unrec- ognized deferred U.S. income tax liability with respect to such earnings is not practicabie. If such earnings are repatriated, additional U.S. income and foreign withholding taxes are sub- stantially expected to be offset by the accompanying foreign tax credits. U.S. federal tax carryforwards at December 31, 1998 consisted of $456 million of net operating losses, $109 mil- lion of investment tax credits and $34 million of alternative minimum tax credits. The utilization of certain carryforwards is subject to limitations under U.S. federal income tax laws. Except for the alternative minimum tax credits which do not expire, the other U.S. federal tax carryforwards expire in vary- ing amounts as follows for income tax reporting purposes: (millions) 1999 2000 2001 2002 Thereafter up to 201 1 Carryforwards Net Investment Operating Tax Losses Credits $ 3 $ 1 t 12 2 35 — 32 450 29 $456 $109 $3,158 $ 3.352 1,112 1,152 �O. MANDATORILY REDEEMABLE PREFERRED SECURITIES 4 4 452 449 4,726 4,g57 304 327 513 38i 217 201 1,235 $ 3,491 2G3 86 99� $ 3.960 Ir August 1995, Time Warner issued approximately 12.1 million Company-obligated mandatorily redeemable preferred securi- ties of a wholly owned subsidiary ("PERCS") for aggregate gross proceeds of $374 million. The PERCS were mandatorily redeemable in December 1997 for an amount per PERCS equai to the lesser of $54.41, and the market value of 1.5 shares of common stock of Hasbro, Inc. (°Hasbro") on December 17, 1997, payable in cash or, at Time Wamer's option, Hasbro common stock. Pursuant to these terms, Time Warner redeemed the PERCS in December 1997 for all of its 18.1 million shares of Hasbro common stock. In con- nection with this redemption and the related disposal of its interest in Hasbro, Time Warner recognized a$200 million pre- tax gain in 1997, which has been classified in interest and other, net, in the accompanying consolidated statement of operations. In December 1995, Time Warner issued approximately 23 million Company-obligated mandatorily redeemable pre- ferred securities of a wholly owned subsidiary (°PrefeRed Trust Securities") for aggregate gross proceeds of $575 million. The sole assets of the subsidiary that is the obligor on the R-eferred Trust Securities are $592 million principal amount of 8'/e% subordinated debentures of TW Companies due December 31, 2025. Cumulative cash distributions are payabie on the Preferred Trust Securities at an annual rate of 8'/s%. The Preferred Trust Securities are mandatorily redeemable for cash on December 31, 2025, and Time Warner has the right to redeem the Preferred Trust Securities, in whole or in pa�, on or after December 31, 2000, or in other certain circumstances, in each case at an amount per Preferred Trust Security equal to $25 plus accrued and unpaid distributions thereon. Time Warner has certain obligations relating to the Preferred Trust Securities which amount to a fuil and uncon- ditional guaranty (on a subordinated basis) of its subsidiary's obligations with respect theceto. 11. REDEMPTION OF SERIES M PREFERRED STOCK In December 199$, Time Warner redeemed all of its out- standing shares of 10'/-% Series M Preferred Stock, which were issued initially in April 1996. The aggregate redemption cost of approximately $2.1 billion was funded with proceeds from the issuance of lower-cost debt. As a result of this redemption, preferred dividend requirements in Time Warner's 1998 consolidated statement of operations include a one-time effect of $234 million ($.19 loss per common share) relating to the redemption premium paid in connection therewith. Because the weighted-average interest rate of the debt is approximately 375 basis points lower than the dividend rate of the Series M Preferred Stock and the interest on the debt is tax deductible (whereas dividends are not), Time Warner , expects to realize approximately $100 to $125 million of annual cash savings as a result of this redemption. 12. SHAREHOLDERS' EQUITY At December 31, 1998, shareholders' equity of Time Warner included 22.6 million shares of convertible preferred stock that are convertible into 94.1 million shares of common stock, 57.1 million shares of Series LMCN-V Common Stock that are convertible into 1 14.2 million shares of common stock and 1.1 18 billion shares of common stock (net of 18.7 million shares of common stock in treasury). Time Warner currently is authorized to issue up to 250 miilion shares of preferred stock, up to 2 billion shares of common stock and up to 200 million shares of additional classes of common stock, including Series LMCN-V Common Stock. In December 1998, a two-for-one common stock split was effectuated by the payment of a 100% stock dividend in the amount of 558.2 million shares of common stock (the "1998 Stock Split"). The 1998 Stock Split did not affect the number of shares of Series LMCN-V Common Stock outstanding. Accordingly, each share of Series LMCN-V Common Stock now is equivalent effectively to two shares of common stock. Shares of Series LMCN-V Common Stock continue to have limited voting rights. During 1998 and January1999, Time Warner issued approximately 66 million shares of common stock in connec- tion with the conversion of 15.8 million shares of con�-ertible preferred stock. These conversions are expected to result in approximately $60 million of cash dividend savings �n the aggregate for Time Warner through the end of 1999. During 1998, Time Warner acquired 59.9 million shares of its common stock at an aggregate cost of $2.24 billion under its existing common stock repurchase program. there5: increasing the cumulative shares purchased to approx�matel�, 95.1 million shares at an aggregate cost of $3.OG bi!iion. Except for repurchases of common stock usin9 borron-ings �� 1998 that offset $1.15 billion of debt reduction asseciated with the conversion of the Zero-Coupon Convertible Notes into common stock, these repurchases were funded �v�!h s2oc- option exercise proceeds and borrowings under Time Warner'= Stock Optfon Proceeds Credit Facility. it�i Y/:��tfJ[kI�lC; I�lnp:,`:';�.:'. n[=':J^.' 8� In January 1999, Time Warner's Board of Directors autho- rized a new common stock repurchase program thaY allows the Company to repurchase, from time to time, up to $5 billion of common stock This program is expected to be completed over a three-year period. However, actual repurchases in any period will be subject to market conditions. Along with stock option exercise proceeds and borrowings under the Stock Option Proceeds Credit Facility, additional funding for this program is expected to be provided by anticipated future free cash fiow and financial capacity. Description Series D preferred stock Series E preferred stock Series F preferred stock Series G preferred stock Series H preferred stock Series I preferred stock Series J preferred stock ................................................ ... .......... ... .... Total shares outstanding at December 31, 1998 Shares Outstanding (millions) 1 1.0 3.t 3.0 t.2 1.8 0.7 1.8 22.6 As of December 31, 1998, Time Warner had approximately 22.6 million shares of convertible preferred stock outstanoii.�. However, in January 1999, all of the outstanding shares of Series G and Series H preferred stock were converted into 12.5 million shares of common stock Set forth below is a summary of the principal terms of Time Wamer's classes of convertible preferred stock: Number of Shares of Common Stock Issuable Upon Conversion (millions) 45.8 13.0 12.4 5.0 7.5 2.9 7.5 94.1 Conversion of Series G and H preferred stock m January 1999 (3,p) ��2,5� _. _.. Total shares outstanding at January 31, 1999 t9.6 8�.6 BZ TIMe" WARNER INC 1998 ANNUAL REPORi Final $3.75 Per Share Dividend Date 7/6/99 1/4/01 1/4/00 9/5/99 9/5/99 t0/2/99 5/2/00 Earliest Exchange Date 7/6/99 1/4/O1 1/4/00 9/5/99 9/5/00 10/2/99 5/2/00 Earliest Redemption Date 7/6/00 1/4/01 1/4/01 9/5/99 9/5/99 10/2/99 5/2/00 The principal terms of each outstanding series of convert- ible preferred stock (collectively, the "l,onvertible Preferred Stock") are similar in nature, unless otherwise noted below. Each share of Convertible Preferred Stock: (1) is entitled to a liquidation preference of $100 per share, (2) is immediately convertible into 4.16528 shares of Time Warner common stock at a conversion price of $24 per share (based on its liquidation value), (3) entitles the holder thereof (i) to receive for a four-year period from the date of issuance (or a five- year period with respect to the Series E and Series J preferred stock) an annual dividend per share equal to the greater of $3.75 and an amount equal to the dividends paid on the Time Warner common stock into which each share may be converted and (ii) to the extent .that any of such shares of preferred stock remain outstanding at the end of the period in which the minimum $3.75 per share dividend is to be paid, the holders thereafter will receive dividends equal to the divi- dends paid on shares of Time Warner common stock multi- plied by the number of shares into which their shares of preferred stock are convertible and (4) entitles the holder thereof to vote with the common stockholders on all matters. on which the common stockholders are entitled to vote, and each share of such Convertible Preferred Stock is entitled to four votes on any such matter: Tiane Warner has the right to exchange each series of Convertible Preferred Stock for Time Warner common stock at the stated conversion price at any time on or after the respective exchange date. In addition, Time Warner has the right to redeem each series of Convertible Preferred Stock, in whole or in part, for cash at the liquidation value plus accrued dividends, at any time on or after the respective redemption date. Pursuant to Time Wamers shareholder rights plan, as amended, each share of Time Warner common stock has attached to it one right, which becomes exercisable in certain events involving the acquisition of 15% or more of the then outstanding common stock of Time Warner on a fully diluted basis. Upon the occurrence of such an event, each right enti- tles its holder to purchase for $75 the economic equivalent of common stock of Time Warner, or in certain circumstances, of the acquiror, worth twice as much. In connection with the plan, 8 million shares of preferred stock were reserved. The rights expire on January 20, 2004. At December 31, 1998, Time Warner had convertible securities and outstanding stock options that were convertible or exercisable into approximately 230 million shares of com- mon stock (as adjusted for the January 1999 conversion of Series G and Series H preferred stock). At February 28, 1999, there were approximately 25,000 holders of record of Time Warner common stock This total does not include the large number of investors who hold such shares through banks, brokers or other fiduciaries. 13. STOCK OPTION PLANS Time Warner has various stock option plans under which Time Warner may grant options to purchase Time Warner common stock to employees of Time Warner and 7WE. Such options have been granted to employees of Time Warner and TWE with exercise prices equal to, or in excess of, fair mar- ket value at the date of grant Accordingly, in accordance with APB 25 and related interpretations, compensation cost is not generally recognized for its stock option plans. Generally, the options become exercisable over a three-year vesting period and expire ten years from the date of grant Had com- pensation cost for Time Warner's stock option plans been determined based on the fair value at the grant dates for all awards made subsequent to 1994 consistent with the method set forth under FASB Statement No. 123, "Accounting for Stock-Based Compensation" ("FAS 123"), Time Warner's net income (loss) and net loss per common share would have been changed to the pro forma amounts indicated below: Years Ended December 31, (millions, except per share amounts) 1998 1997 1996 Net income (loss): As reported $168 $ 246 $ (19 t ) Pro forma $ 106 $ 200 $ (216) Net loss per comrnon share: As reported $ (.31) $ (.06) $ (.52) Pro forma $ (.36) $ (.10) $ (.55) 71NF WANNFR INC. 149F1 AN��:J%.'. RFPORT B3 FAS 123 is applicable only to stock options granted subse- quent to December 31, 1994. Accordingly, since Time Warner's compensation expense associated with such grants would gen- erally be recognized over a three-year vesting period, the initial impact of applying FAS 123 on pro forma net income for 1996 is not comparable to the impact on pro forma net income for 1998 and 1997, when the pro forma effect of the three-year vesting period has been fully reflected. For purposes of applying FAS 123, the fair value of each option grant is estimated on the date of grant using the Black- Scholes option-pricing model with the following weighted- average assumptions used for grants in 1998, 19g7 and 1996: dividend yields of 0.5%, 1% and 1%, respectively; expected volatility of 21.6%, 21.9% and 21.7%, respectively; risk-free interest rates of 5.5%, 6.4a/o and 6.1%, respectively; and expected lives of 5 years in all periods. The weighted aver- age fair value of an option granted during the year was $11.13 ($6.57, net of taxes), $6.58 ($3.88, net of taxes) and $5.78 ($3.41, net of taxes) for the years ended December 31, 1998, 1997 and 1996, respectively. In each period, Time Warner granted options to certain executives at exercise prices exceed- ing the market price of Time Warner common stock on the date of grant These above-market options had a weighted average exercise price and fair value of $49.54 and $9.45 ($5.58, net of taxes), respectively, in 1998; $32.45 and $6.29 ($3.71, net of taxes), respectively, in 1997; and $26.44 and $4.44 ($2.62, net of taxes), respectively, in 1996. A summary of stock option activity under all plans is as follows: Weighted- Thousands Average of Exercise Shares Price Balance at January 1, 1996 � 57,238 $� 5.68 Granted 18,920 21.65 Exercised (7,372) 13.45 Assumed in connection with the TBS Transaction 27,425 13.20 Cancelled _ ..............._.._._..................................................................,......................._.................,............................_�477) 20.41 _...... - Balance at December 31, 1996 195,734 $ 15.gg Granted t6,544 22.41 Exercised (32,632) 13.66 Cancelled _ ..................._............................................ _............. ._._._...... .._..............._ .. ........ . _ (942) 18.89 .. .............. ... Balance at December 31, 1997 i 78,704 $ t 6.gg Granted t8,t00 3Z71 Exercised (48,323) 15.01 Cancelled ............ . . ... . ..... .. (417) 28.01 _..... . ..... ... _ _....... Balance at December 31, 1998 148,064 $ 20.14 December 31, (thousands) 1998 1997 1996 Exercisable 112,471 7 45,616 165,394 Available for future grants 11,207 12,771 t6,063 The following table summarizes information about stock options outstanding at December 31, 1998: Ranoe of Exercise Prices Under $10 $10.00 to $15.00 $15.01 to $20.00 $20.01 to $30.00 $30.01 to $45.00 $45.01 to $54.05 _ . _ ... . Total Number Outstanding at 12/31 /98 (thousands) 7,726 25,239 59,851 35.538 16,573 3.137 _ 148,064 Options Outstanding Weighted- Average Remaining Contractual Life 1.7 years 3.1 years 4.3 years 6.4 years 8.9 years 9. i years 5.1 years For options exercised by employees of TWE, Time Warner is reimbursed by TWE for the amount by which the market value of Time Wamer common stock on the exercise date exceeds the exercise price, or the greater of the BG TIME bVARNER INC 19��d �NNUAL REPORi Weighted- Average Exercise Price $ 8.98 $12.14 $18.20 $ 22.02 $35.09 $48.44 $20.14 Options Exercisable Number Weighted- Exercisable Average at 12/31 /98 Exercise (thousands) Price 7,726----- $ 8.98 25,239 $12.14 55,545 $18. 7 6 23,056 $21.73 905 $31.75 1 12,471 $ 17.02 exercise price or $13.88 for options granted prior to the TWE capitalization on June 30, 1992. There were 4Z7 million options held by employees of TWE at December 31, 1998, 33.4 million of which were exercisable. 14. BENEFIT PLANS Time Warner and its subsidiaries have defined benefit pension plans covering substantially all domestic employees. Pension benefits are based on formulas that reflect the employees' years of service and compensation levels during their employment period. Time Warner's common stock represents approximately 12% and 7% of plan assets at December 31, 1998 and 1997, respectively. A summary of activity for Time Warner's defined benefit pension plans is as follows: Years Ended December 31, (millions) 1998 1997 1996 Components of Pension Expense Seroice cost $ 53 $ 45 $ 49 Interestcost 74 68 64 Expected return on plan assets (73) (62) (57) Net amortization and deferral 2 t q _._..__......_....._..._._._...---�---- --------- ................_.. _...._. Total $ 56 $ 52 $ 60 December 31, (millions) 1998 1997 �; Change in Projected Benefit Obligation Projected benefit obligation � at beginning of year $ 990 $ 850 j Service cost 53 45 Interest cost 74 68 Actuarialloss 98 78� Benefits paid (52) (51; _....... _ _... __._ _ _ _.._... Projected benefit obl�gation _at end of year...._ ................................... 1,163 990 _.. _.. . _ .._ _ Change in Plan Assets Fair value of plan assets at beginning of year 839 704 Actual return on plan assets 191 t 62 Employer contribution 16 15 Benefits paid (46) (42) _.. . _ .__.._. . _ ._...... _. . _ Fair value of plan assets at end of year 1,000 839 _. Unfunded projected benefit obligation (163) (t 51) � Additional minimum liability�a> (33) (38) Unrecognized actuarial loss (gain) (16) 3 Unrecognized prior service cost 16 15 _... .._ . _. Accrued pension expense $ (196) $(17i) (a) The additional minimum Ilability is olfset fully by a corresponding �ntang�ble asset recognized m the consolidated balance sheet. December 31, 1998 1997 1996 Weighted-Average Pension Assumptions Discount rate 6.75% 7.25% 7.75% Expected return on plan assets 9% ga/o g% Rate of compensation increase 69�0 6% 6% Included above are projected benefit obligations and accumulated benefit obligations for unfunded defined benefit pension ptans of $118 million and $97 million as of December 31, 1998, respectively; and $94 million and $72 million as of December 31, 1997, respectively. Employees of Time Warner's operations in foreign coun- tries participate to varying degrees in local pension plans, which in the aggregate are not significant. Time Warner also has certain defined contribution plans, including savings and profit sharing plans, as to which the expense amounted to $84 million in 1998, $83 million in 1997 and $67 million in 1996. Contributions to the savings plans are based upon a percentage of the employees elected contributions. Contributions to the profit sharing plans are generally determined by management and approved by the boards of directors of the participating companies. 15. DERIVATIVE FINANCIAL INSTRUMENTS Time Warner uses derivative financial instruments principally to manage the risk that changes in interest rates wi�l affect either the fair value of its debt obligations or the amount of its future interest payments and, with regard to foreign cur- rency exchange rates, to manage the risk that changes in exchange rates will affect the amount of unremitted or future royalties and license fees to be received from the sale of U.S. copyrighted products abroad. The following is a sum- mary of Time Warner's risk management strategies a�d the effect of these strategies on Time Warner's consolidated financial statements. Interest Rate Risk Management Inte�est Rate Swap Contracts Interest rate swap contracts are used to adjust the propor- tion of total debt that is subject to variable and fixed interest rates. Under an interest rate swap contract, Time Warner either agrees to pay an amount equal to a specified vari- able-rate of interest times a notional principal amount, and to receive in return an amount equal to a specified fixed-rate of interest times the same notional principal amount or. vice IIMf WARNCR INC 1998 �NNU:._. �_ "()177 8S versa, to receive a variable-rate amount and to pay a fixed- rate amount The notional amounts of the contract are not exchanged. No other cash payments are made unless the contract is terminated prior to maturity, in which case the amount paid or received in settlement is established by agreement at the time of termination, and usually represents the net present value, at current rates of interest, of the remaining obligations to exchange payments under the terms of the contract. Interest rate swap contracts are entered into with a number of major financial institutions in order to minimize counterparty credit risk. Time Warner accounts for its interest rate swap contracts differently based on whether it has agreed to pay an amount based on a variable-rate or fixed-rate of interest. For interest rate swap contracts under which Time Warner agrees to pay variable-rates of interest, these contracts are considered to be a hedge against changes in the fair value of Time Warner's fixed-rate debt obligations. Accordingly, the inter- est rate swap contracts are reflected at fair value in Time Warner's consolidated balance sheet and the related portion of fized-rate debt being hedged is reflected at an amount equal to the sum of its carrying value plus an adjustment representing the change in fair value of the debt obligatio.ns attributable to the interest rate risk being hedged. In addition, changes during any accounting period in the fair value of these interest rate swap contracts, as well as offsetting changes in the adjusted carrying value of the related portion of fixed-rate debt being hedged, are recognized as adjust- ments to interest expense in Time Warner's consolidated statement of operations. The net effect of this accounting on Time Warner's operating results is that interest expense on the portion of fixed-rate debt being hedged is generally recorded based on variable interest rates. For interest rate swap contracts under which Time Warner agrees to pay fixed-rates of interest, these contracts are considered to be a hedge against changes in the amount of future cash flows associated with Time Warner's interest payments of Time Warner's variable-rate debt obiigations. Accordingly, the interest rate swap contracts are reflected at fair value in Time Warner's consolidated balance sheet and the related gains or losses on these contracts are deferred in shareholders' equity (as a component of comprehensive income). These deferred gains and losses are then amortized as an adjustment to interest expense over the same period in which the related interest payments being hedged are rec- ognized in income. However, to the extent that any of these contracts are not considered to be perfectly effective in offsetting the change in the value of the interest payments 86 7IMf wnf2111 R IN(: tyAR nn•n'UA�. REPOR7 being hedged, any changes in fair value relating to the inef- fective portion of these contracts are immediately recognized in income. The net effect of this accounting on Time Warner's operating results is that interest expense on the portion of variabie-rate debt being hedged is generally recorded based on fixed interest rates. At December 31, 1998, Time Warner had interest rate swap contracts to pay variable-rates of interest (average six- month LIBOR rate of 5.5%) and receive fixed-rates of inter- est (average rate of 5.5%) on $1.6 billion notional amount of indebtedness, which resulted in approximately 37% of Time Warner's underlying debt, and 39% of the debt of Time Warner and the Entertainment Group combined, being subject to variable interest rates. The notional amount of outstanding contracts by year of maturity at December 31, 1998 is as follows: 1999-$1.2 billion; and 2000-$400 million. At December 31, 1997, Time Warner had interest rate swap contracts on $2.3 billion notional amount of indebtedness. The net gain or loss on the ineffective portion of these interest rate swap contracts was not material in any period. Inferesf Rate Lock Agreements In the past, Time Warner sometimes has used interest rate lock agreements to hedge the risk that the cost of a future issuance of fixed-rate debt may be adversely affected by changes in interest rates. Under an interest rate lock agree- ment, Time Warner agrees to pay or receive an amount equal to the difference between the net present value of the cash fiows for a notional principal amount of indebtedness based on the existing yield of a U.S. treasury bond at the date when the agreement is established and at the date when the agree- ment is settled, typically when Time Warner issues new debt. The notional amounts of the agreement are not exchanged. Interest rate lock agreements are entered into with a number of major financial institutions in order to minimize counter- party credit risk. Interest rate lock agreements are reflected at fair value in Time Warner's consolidated balance sheet and the related gains or losses on these agreements are deferred in share- holders' equity (as a component of comprehensive income). These deferred gains and losses are then amortized as an adjustment to interest expense over the same period in which the related interest costs on the new debt issuances are recognized in income. At December 31, 1998, Time Warner had outstanding interest rate lock agreements for an aggregate $650 million notional principal amount of indebtedness, which were settled in January 1999. Time Warner no longer intends to use interest rate lock agreements to hedge the cost of future issuances of fixed-rate debt At December 31, 1998, Time Warner had deferred approximately $32 million of net losses on interest rate lock agreements, of which approx- imately $2 million is expected to be recognized in income over the next twelve months. Foreign Currency Risk Management Foreign exchange contracts are used primarily by Time Warner to hedge the risk that unremitted or future royalties and license fees owed to Time Warner or TWE domestic companies for the sale or anticipated sale of U.S. copyrighted products abroad may be adversely affected by changes in foreign currenty exchange rates. As part of its overall strategy to manage the levei of exposure to the risk of foreign currenry exchange rate fluctua- tions, Time Warner hedges a portion of its and TWE's com- bined foreign currency exposures anticipated over the ensuing twelve-month period. At December 31, 1998, Time Warner had effectively hedged approximately half of the combined estimated foreign currency exposures that principally relate to anticipated cash flows to be remitted to the U.S. over the ensuing twelve-month period: To hedge this exposuce, Time Wamer used foreign exchange contracts that �generally have maturities of three months or less, which generally will be colled over to provide continuing coverage throughout the year. Time Warner often closes foreign exchange sale con- tracts by purchasing an offsetting purchase contract Time , Warner reimburses or is reimbursed by TWE for contract gains and losses related to TWE's foreign currency exposure. Foreign exchange contracts are placed with a number of major financial institutions in order to minimize credit risk. Time Warner records these foreign exchange contracts at fair value in its consolidated balance sheet and the related gains or losses on these contracts are deferred in sharehold- ers' equity (as a component of comprehensive income). These deferred gains and losses are recognized in income in the period in which the related royalties and license fees being hedged are received and recognized in income. However, to the extent that any of these contracts are not considered to be perfectly effective in offsetting the change in the value of the royalties and license fees being hedged, any changes in fair value relating to the ineffective portion of these contracts are immediately recognized in income. Gains and losses on foreign exchange contracts are generally included as a component of interest and other, net, in Time Warner's consolidated statement of operations. At December 31, 1998, Time Warner had contracts for the sale of $755 million and the purchase of $259 million of foreign currencies at fixed rates, primarily Japanese yen (40% of net contract v�iue), English pounds (4%), German marks (28°/a), Canadian dollars (10%) and French francs (16%), compared to contracts for the sale of $507 million and the purchase of $139 million of foreign currencies at December 31, 1997. Time Warner had deferred approxi- mately $6 million of net losses on foreign exchange con- tracts at December 31, 1998, which is all expected to be recognized in income over the next twelve months. For the years ended December 31, 1998, 1997 and 1996, Time Warner recognized $8 miliion in losses, $27 million in gains and $15 million in gains, respectively, and TWE recognized $2 million in losses, $1� million in gains and $6 million in gains, respectively, on foreign exchange contracts, which were or are expected to be offset by corresponding decreases and increases, respectively, in the dollar value of foreign currency royalties and license fee payments that have been or are anticipated to be received in cash from the sale of U.S. copyrighted products abroad. 16.SEGMENT INFORMATION Time Warner classifies its businesses into four fundamental areas: Cab/e Networks, consisting principally of interests in cable television programming; Publishing, consisting princi- pally of interests in magazine publishing, book publishing and direct marketing; Entertainment, consisting principally of interests in recorded music and music publishing, filmed entertainment, television production and television broadcast- ing; and Cable, consisting principally of interests in cable television systems. A majority of Time Warner's interests in filmed entertainment, television production, television broadcast- ing and cable television systems, and a portion of its interests in cable television programming are held by the Entertainment Group. The Entertainment Group is not consolidated for finan- cial reporting purposes. Information as to the operations of Time Warner and the Entertainment Group in different business segments is set forth below based on the nature of the products and services offered. Time Warner evaluates performance based on several factors, of which the primary financial measure is business segment operating income before noncash amortization of intangible assets ("EBITA"). The accounting policies of the business segments are the same as those described in the summary of significant accounting policies (Note 1). Intersegment sales are accounted for at fair value as if the sales were to third parties. fIMF. WARNER InC. 199B ANf�UA: ��' �'��Ri 87 The operating results of Time Wamers and the Entertainment Group's cable segments reflect the TV�r-A/N Transfers effective as of January 1, 1998, the Primestar Roll-up Transaction effective as of April 1, 1998, the formation of the Road Runner Joint Venture effective as of June 30, 1998 and the Time Warner Telecom Reorganization effective as of July 1, 1998. In addi- tion, the operating results of Time Warner reflect the cable networks and filmed entertainment-related acquisition of TBS effective as of October 10, 1996. Years Ended December 31, (millions) 1998 1gg7 lggg Revenues Time Warner: Publishing $ 4,496 $ 4,290 $ 4,i 17 Music 4,025 3,691 3,949 Cable Networks-TBS 3,325 2,900 680 Filmed Entertainment-TBS 1,917 1,531 455 Cable 964 997 gpg Intersegment elimination (145) (115) (46) ............................................ ................. ............................._......._............... ....... .. ... __. Total $14,582 -$13,294. $10,064 EnteRainment Group: Filmed Entertainment- Warner Bros. $ 6,061 $ 5,472 '$ 5,648 Broadcasting- The WB Network 260 136 87 Cable Networks-HBO 2,052 t,923 1,763 Cable 4,378 4,243 3,851 Intersegment elimmation (495) (446) (488) _.. _........ _......,._.._.. Total $12,256 $1 1,328 $10,861 SH TIM[ �'; .RNf:R INC 199P FNhUAL REPORT Years Ended December 31, (millions) 1998 1gg7 1gg6 EBITA�» . Time Wamer: Publishing $ 607 $ 529 $ 464 Music 493 467 653 Cable Networks-TBS 706 573 142 Filmed Entertainment TBS 192 200 30 Cable�2> 325 427 353 Intersegment elimination (27) (13) 5 ........._...__......_._..........._..._ .............._........_.............._...�.............__....�.._...._..._._.._...._..._.._..._........... _.�.. .._.. Total $ 2,296 $ 2,183 $1,647 Entertainment Group: Filmed Entertainment- Warner Bros. $ 503 $ 404 $ 379 Broadcasting- The WB Network (93) (88) (gg) . Cable Networks-HBO 454 39i 328 Cable�3� 1,369 1,184 917 _ .........................._....................... . _ ................. ....................................._....._..........._ Total $ 2,233 $1,891 $1,526 (1) EBITA represents business segment operating income before noncash amortiiation of intangible assets. After deducting amortization of intangible assets, Time Warners business segment operating income was $1.496 billion in 1998, $1271 billion in 1997 and $966 million in 1996. Similarly, business segment operating income of the EnteRainment Group was $1.724 billion in 1998, $1.461 billion in 1997 and $1.090 billion in 1996. (2) Includes net pretaz gains of approximately $18 million in 1996 and $12 million . in 1997 related to the sale or exchange o( certain cable television systems. (3) Includes net pretax gains of approximately $90 million in 1998 and $200 million ir 1997 related to the sale or exchange of certain cable television systems. Years Ended December 31, (millions) 1998 1997 1gg6 Depreciation of Property, Plant and Equipment Tme Warner: Publishing $ gp $ 79 $ �� Music 72 83 9� Cable Networks-TBS 93 87 20 Filmed Entertainment-TBS 6 7 2 Cable 127 126 123 _._. _... __........... Total $ 378 $ 382 $ 307 EnteRainment Group: Filmed Entertainment- Warner Bros. $ � gg g � g� $ � 6� Broadcasting- The WB Network 1 � _ Cable Networks-HBO 23 22 22 Cable 737 736 619 Total $ 927 $ 956 $ 808 Years Ended December 31, (millions) 1998 1997 1996 Amortization of Intangible Assets�>> Time Wamer: Publishing $ 38 $ 48 $ 46 Music 280 301 292 Cable Networks-TBS 200 199 43 Filmed Entertainment TBS 82 87 22 Cable 200 277 278 --�- ---...___�___.._.._.._.......--•-----------...__..._...._...__.._..----__...___.._.._---- Total $ 800 $ 912 $ 68 t Entertainment Group: Filmed Entertainment- Warner Bros. $ 129 $ t 23 $ 125 Broadcasting- The WB Network 3 - - Cable Networks-HBO - - - Cable 377 307 311 _._..._...._....... . _.. ..................................._............................ ................................_......._..._..................._............__....................__.... Total $ 509 $ 430 $ 436 (1) Amort�zation includes amortizatian relating to all business combinations accour,:ed for by the purchase method, including the $14 billion acquisition of Warne• Communications Inc. in 1989, the $6.2 billion acquisition of TBS in 1996 and the $2.3 billion of cable acquisitions in 1996 and 1995. Information as to the assets and capital expenditures of Time Warner and the Entertainment Group is as follows: Decembe� 31, (millions) 1998 1997 1996 Assets Time Warner: Publishing $ 2,726 $ 2,490 $ 2,418 Music 7,354 6,507 7,478 Cabte Networks-TBS 8,485 8,372 7,860 Filmed Entertainment-TBS 2,774 2,950 3,232 Cable 4,434 7,043 7,257 Entertairment Group�� 4,980 5,549 5,814 Corporate�2> 887 t,252 1,005 _...._ _ _. . . Total $ 31,640 $ 34, t 63 $ 35,064 Entertainment Group: Filmed Entertainment- Warner Bros. $ 8,811 $ 8,106 $ 8,1 1 1 Broadcasting- The WB Network 244 t 13 67 Cable Networks-HBO 1,159 t,080 997 Cable 11,314 7 0,77 � 10,202 Corporate�2� 713 669 650 _.. _ Total $ 22,241 $ 20,739 $ 20,027 (1) Ent?rta ^?+ent Group assets represent T�me Wamer's �nvesiment �n and amou^'s due fo and from the Ente�tainment Group. (2) Cons��s's �rincipally of cash, cash equ��aients and other �n�esiments. Years Ended December 31, (millions) 1998 1997 tgg6 Capital Expenditures Tme Wamer. Publishing $ 58 $ 77 $ 76 Music 92 87 t 42 Cable Networks TBS 120 t 13 34 Filmed Entertainment TBS 3 3 2 Cable 225 282 2 i 5 Corporate 14 12 t 2 _ ._._._._.__...___._ ............._._...._.._.........._...._...._..............._............_....................._....--- Total $ 512 $ 574 $ 481 Entertainment Group: Filmed Entertainment- Warner Bros. $ 122 $ 144 $ 3=0 Broadcasting- The WB Network � � 2 Cable Networks-HBO 23 1g 2g Cable�� 1,451 1,40t 1.3=8 Corporate g - _ _._......_..__......_.........__ _....__......._ .............._........_..._...__...... _............. . . ,. _ .. ._ ..... ... Total $1,603 $1,565 $�.7'9 (t) Cable capital ezpenditures were funded in part through collections on the MediaOne Note Receivable in the amount of $169 million in 1996 (Note 4!. The MediaOne Note Receivable waz fully collected during 1996. TiMF wARNER INC. 19J8 Arrf�UAL REPO=� SJ Information as to Time Warner's operations in different geograp�.ical areas is as follows: Years Ended December 31, (millions) 1998 1997 1gg6 Revenues�» Time Waroer: United States $11,220 $10,159 $ 7,262 United Kingdom 542 449 372 Germany 432 420 452 Japan 405 417 399 Canada 284 262 209 France 227 � g5 229 Other international 1,472 1,392 1,141 �.__...�_._._..__.__._�._....____._... .__...._..._.._.._..._...-----._........----...._._.....�...._... Total $14,582 $13,294 $10,064 Entertainment Group: United States $10,177 $ 9,096 $ 8,727 United Kingdom 459 488 383 Germany 263 284 374 Japan 162 . t72 t96 Canada 145 137 157 France 163 . 152 143 Other international g87 ggg 881 _.....__._ ............................................__.................._........................................................................ ..... .. .............................._ ............ Total $12,256 $ t t,328 $ t 0,861 (1) Revenues are attributed to countries based on location of customer. Because a substantial portion of Time Wamets internationai revenues is derived from the sale of U.S. copyrighted products abroad, assets located outside the United States are not materiai. 17. COMMITMENTS AND CONTINGENCIES Time Warner's total rent expense amounted to $286 million in 1998, $237 million in 1997 and $192 miliion in 1996. The minimum rental commitments under noncancellable long-term operating leases are: 1999-$259 million; 2000- $244 million; 2001-$222 million; 2002-$205 million; 2003-$193 million and after 2003-$940 million. Time Warner's minimum commitments and guarantees under certain programming, licensing, artists, athletes, franchise and other agreements aggregated approximately $6.6 billion at December 31, 1998, which are payable princi- pally over a five-year period. Such amounts do not include the Time Warner General Partner and TWI Cable guarantees of approximately $6.7 billion of TWE's and TWE-A/N's debt and accrued interest. 90 TIME WARNER INC. �998 ANNUAI RfPOR7 Time Warner is subject to numerous legal proceedings, including certain litigation relating to Six Flags. In manageme��t's opinion and considering established reserves, the resolution of these matters will not have a material effect, individually and in the aggregate, on Time Warner's financial statements. 18. R.ELATED PARTY TRANSACTIONS In the normal course of conducting their businesses, Time Warner and its subsidiaries and affiliates have had various transactions with NVE and other Entertainment Group com- panies, generally on terms resulting from a negotiation between the affected units that in management's view resu�ts in reasonable allocations. Employees of TWE participate in various Time Warner medical, stock option and other benefit plans for which Time Warner charges TWE its allocable share of plan expenses, including administrative costs. In addition, Time Warner provides TWE with certain corporate support services for which it received a fee in the amount of $72 million, $72 million and $69 million in 1998, 1997 and 1996, respectively. Time Warner's Cable division has management services agreements with TWE, pursuant to which NVE manages, or provides services to, the cable television systems owned by Time Warnec Such cabie television systems also pay TWE for the right to carry cable television programming provided by TWE's cabie networks. Similarly, Time Warner receives fees from TWE's cable television systems for the right to carry cable television programming provided by Time Warner's cable networks. Time Warner's and TWE's Cable division have sold or exchanged, or agreed to sell or exchange, various cable tele- vision systems to MediaOne in an effort to strengthen their geographic clustering of cable television properties. Time Warner's Filmed Entertainment-TBS division has vari- ous service agreements with TWE's Filmed Entertainment- Warner Bros. division, pursuant to which TWE's Filmed Entertainment-Warner Bros. division provides certain manage- ment and distribution services for Time Warner's theatrical, television and animated product, as well as certain services for administrative and technical support. Time Warner's Cable Networks-TBS division has license agreements with TWE, pursuant to which the cable net- works have acquired broadcast rights to certain film and television product. In addition, Time Warner's Music division provides home videocassette distribution services to certain NVE operations, and certain TWE units place advertising in magazines published by Time Warner's Publishing division. Time Warner has a credit agreement with TWE that allows it to borrow up to $400 million from TWE through September 15, 2000. Outstanding borrowings from TWE in the amount of $400 million bear interest at LIBOR plus 1 % per annum. In addition to transactions with �NE and other Entertainment Group companies, Time Wamer has had transactions with the Columbia House Company partnerships, Comedy Partners, LP, Time Warner Telecom, the Road Runner Joint Venture and other equity investees of Time Wamer and the Entertainment Group, generally with respect to sales of products and services in the ordinary course of business. 19. ADDITIONAL FINANCIAL INFORMATION Cash Flows As of December 31, 1998, Time Warner had certain asset securitization facilities, which provide for the accelerated receipt of up to approximately $1 billion of cash on available receivables. In connection with each of these securitization facilities, Time Warner sel�s, on a revolving and nonrecourse basis, certain of its accounts receivables (°Pooled Receivables") to a wholly owned, special purpose entity which, in turn, sells a percentage ownership interest in the Pooled Receivables to a third-party, commercial paper conduit spon- sored by a financial institution. These securitization transactions have been accounted for as a sale in accordance with FASB Statement No. 125, Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities.° Accordingly, accounts receivables sold under this securitization prog�am have been reflected as a reduction in receivables in the accompanying consolidated balance sheet. Net proceeds received under this securitization program were $17 million in 1998, $108 million in 1997 and $147 million in 1996. Additional financial information with respect to cash flows is as follows: Years Ended December 31, (millions) 1998 1997 1996 Cash payments made for interest $ g� 2 g g2g $$39 Cash payments made for income taxes 261 305 382 Tax-related distributions received from TWE 314 324 2�5 Income tax refunds received 52 52 4a Noncash investing activities in 1998 included the Time Warner Telecom Reorganization, the formation of the Road Runner Joint Venture and the TWE-A/N Transfers (Note 2). Noncash financing activities included the conversion of $1.15 billion of Zero-Coupon Convertible Notes into 37.4 million shares of common stock in 1998 (Note 7) and the conversion of 12.8 million shares of convertible preferred stock into approximately 53.5 million shares of common stock (Note 12). Noncash financing activities in 1997 included the redemption of the PERCS in exchange for Time Warner's interest in Hasbro {Note 10) and the payment of $185 million of noncash dividends on the Series M PreferrecJ Stock. Noncash investing activities in 1996 included the $6.2 billion acquisition of TBS and the $904 million acquisi- tion of CVI in exchange for capital stock (Notes 2 and 3). Noncash financing activities in 1996 included the payment of $122 million of noncash dividends on the Series M Preferred Stock. Other Current Liabilities Other current liabilities consist of: December 31, (millions) 1998 1997 Accrued expenses $1,542 $1,716 Accrued compensation 538 430 Accrued income taxes g3 2g Deferred revenues 231 205 _. _._. .. __ _. _. _.._ _......_. .. Total $2,404 $2,379 �. :-.�,,:�� ,..� .,.., .. _, � �:: �,�,�,�� ei Report of l�ianagement The accompanying consolidated financial statements have been prepared by management in conformity with generally accepted accounting principles, and necessarily include some amounts that are based on management's best esti- mates and judgments, Time Warner maintains a system of internal accounting controls designed to provide management with reasonable assurance that assets are safeguarded against loss from unauthorized use or disposition, and that transactions are executed in accordance with management's authorization and recorded properly. The concept of reasonable assurance is based on the recognition that the cost of a system of internal control should not exceed the benefits derived and that the evaluation of those factors requires estimates and judgments by management. Further, because of inherent limitations in any system of internai accounting control, errors or irregularities may occur and not be detected. Nevertheless, management believes that a high level of internal control is maintained by Time Warner through the selection and training of qualified personnel, the establish- ment and communication of accounting and business policies, and its internal audit program. The Audit Committee of the Board of Directors, com- posed solely of directors who are not employees of Time Warner; meets periodically with management and with Time Warner's internal auditors and independent auditors to review matters relating to the quality of financial reporting and inter- nal accounting controi, and the nature, extent and results of their audits. Time Warner's internal auditors and independent auditors have free access to the Audit Committee. ��-��-� Richard J. Bressler Executive Vice President and Chief Financial Officer %!Z �'^—`�,LL�E�� John A. LaBarca Senior Vice President and Controller 92 TIME WARNER INC. 1998 ANNUAL REPORT Report of Independent Auditors The Board of Directors and Shareholders Time Warner Inc. We have audited the accompanying consolidated balance sheet of Time Warner Inc. ("Time Warner") as of December 31, 1998 and 1997, and the related consoli- dated statements of operations, cash flows and sharehold- ers' equity for each of the three years in the period ended December 31, 1998. These financial statements are the responsibility of Time Warner's management. Our responsi- bility is to express an opinion on these financiai state- ments based on our audits. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to �btain reasonable assur- ance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclo- sures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financiai statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the financial statements referred to above present fairly, in all material respects, the consoli- dated financial position of Time Warner at December 31, 1998 and 1997, and the consolidated results of its opera- tions and its cash fiows for each of the three years in the period ended December 31, 1998, in conformity with gen- erally accepted accounting principles. � f ��« Ernst & Young LLP New York, Ne�v York February 3. 1999 Selected Financial Information The selected financial information for each of the five years in the period ended December 31, 1998 set forth below has been derived fro�n and should be read in conjunction with the financial statements and other financial information presented elsewhere herein. Capitalized terms are as defined and described in such consolidated financial statements, or elsewhere herein. The selected historical financial information for 1998 reflects (a) the TWE-A/N Transfers and (b) the redemption of Series M Preferred Stock at an aggregate cost of approximately $2.1 billion using proceeds from the issuance of lower-cost debt The selected historical financial information for 1996 reflects (a) the TBS Transaction, including the assumption of approximately $2.8 billion of indebtedness, (b) the use of approximately $1.55 billion of net proceeds from the issuance of Series M Preferred Stock to reduce outstanding indebtedness and (c) the acquisition of CVI, including the assumption or incurrence of approximately $2 billion of indebtedness. The selected historical financial information for 1995 reflects (a) the acquisitions of KBLCOM Incorporated and Summit Communications Group, Inc., including the assumption or incurrence of approximately $1.3 billion of indebtedness and (b) the exchange by Toshiba Corporation and ITOCHU Corporation of their direct and indirect interests in TWE. Per common share amounts and average common shares have been restated to give effect to the two-for-one common stock split that o�curred on December 15, 1998. Selected Operating Statement Information Years Ended December 31, (millions, except per share amounts) Revenues Depreciation and amortization Business segment operating income�a� Equity in pretax income of Entertainment Group�b>. Interest and other, net<<> Income (loss) before extraordinary item Net income (loss)�d> Net loss applicable to common shares (after preferred dividends)�d)(e> Per share of common stock: Basic and diluted net loss �d)(e> Dividends 1998 $14,582 (1,178) 1,496 356 (1,180) 168 168 1997 $13,294 (1,294) 1,271 686 (1,044) 301 246 (372) (73) $ (0.31) $ (0.06) $ 0.18 $ O.tB ..� $10,064 (988) 966 290 (1,174) (156) (19i) 1995 $ 8,067 (559) 697 256 (877) (124) (166) (448) (218) $ (0.52) $ (028) $ 0.18 $ 0.18 1994 $ 7,396 (437) 713 176 (724) (91) (9t) (104) � (0.1 a) SO.� ;5 Average common shares 1,194.7 1,135.a 862.4 767.6 — --- ; 5?.8 (a) Business segment operating income for the year ended December 31, 1995 includes $85 m�lhon �n losses reiatmg to certam ous�nesses and joint ventures owr,ec �. � Music division which were restructured or closed. (b) Time Wamer's equity in the pretau income of the E�tertainment Group for the years ended December 3�, t 998 and 1997 inctudes approzimately $120 million of �e: ._ c;�; and $450 million oi gains, respectively, relating to the sale or exchange of vanous cable telev�sion sys;ems and other Investment-related activity. (c) Interest and othe�, net for the year ended December 31, 1997 includes z 5200 m�ilwn pretaz gain relabno to the d�sposal o` T�me Warner's mterest in Hasbro anC �-e •e ;-e� redemption of certain mandatorily redeemable prefened securities of a suos�diary. (d) Net income poss) for each of the years ended December 31, 1997, 1gg6 and 1995 includes an extrao�d�nary loss on the retirement of debt of $55 million ($AS pr co-.-,on share), $35 million ($.04 per common share) and $42 million ($.05 per common share), respectrvely. (e) Preferred dividend requirements for the year ended December 31, 1998 indude a one-time eftect of $23e mdhon ($.7 g loss pe� common share) relating to the pre�- ,,^. pz c in connection with the redemption ot Time Warner's Series M Preferred StocK. n�sr wnr;Nru iNr. i�uN nn�rz;in� �,_ , � 93 Selected Balance Sheet Information December 31, (millions) 1998 1997 1996 1995 1994 Cash and equivalents $ 442 $ 645 $ 514 $ t,ig5 $ 2g2 Total assets 31,640 34,163 35,064 22,132 16,716 Debt due within one year 19 8 1 1 34 355 Long-term debt 10,925 11,833 12,713 9,907 8,839 Borrowings against future stock option proceeds 895 533 488 - - Company-obligated mandatorily redeemable preferred securities of subsidiaries 575 575 949 gqg - Series M exchangeable preferred stock - 1,857 t,672 - - Shareholders' equity: Preferred stock liquidation preference 2,260 3,539 3,559 2,994 t 40 Equity applicable to common stock 6,592 5,817 5,943 673 1,008 Total shareholders' equity 8,852 9,356 9,502 3,667 1,14g Total capitalization 21,266 24,162 25,335 14,557 10,342 9Q TIM[ W/�RNER INC, i99A nNNUnI Rf�V'ORT Quarterly Financial Information cunaua�ted� Equity Net in Pretax Income Bazic Diluted Opereting I�come (Loss) Income Income Dividends Income of (Loss) of Net Applicable (Loss) Per (Loss) Per Per Average Business Entertainment Income to Common Common Common Common Common Common StockCv� Cluarter Revenues Segments Group (Loss) Shares�� Share��x�cv� Share<<x� Share�� Shares� High Low (millions, except per share amounts) 1998 1 st $ 3,137 $ 170 $ 107 $ (62) $ (144) $ (0.12) $ (0.12) $ 0.045 1,156.6 2nd��b> 3,672 384 166 101 23 0.02 0.02 0.045 1,192.6 3rd 3,578 315 164 39 (37) (0.03) (0.03) 0.045 1,202.6 4th�a��b� 4,195 627 (81) 90 (214) (0.17) (0.17) 0.045 1;227.2 Year��b� 14,582 1,496 356 168 (372) (0.31) (0.31) 0.180 1,194.7 1997 � �(cXa) $ 3,034 $ 194 $ 318 $ 35 $ (43) $ (0.04) $ (0.04) $ 0.045 1,117.8 2nd 3,193 345 108 30 (49) (0.04) (0.04) 0.045 1,122.0 3rd<<� 3,231 263 96 (35) (116) (0.10) (0.10) 0.045 1,146.6 4th<<xd> 3,836 469 164 216 135 0.12 0.11 0.045 1,155.0 Year��Xd) 13,294 1,271. 686 246 (73) (0.06) (0.06) 0.180 1,135.4 $37'/. $2g'F.5 44�e 36'/+e 50 39 63'6 ' 37�Fe 63'k 29�s $ 22! $18?'= 253� 20i: 28�f6 19 Y: 31 26Y: 31 18�: (a) As indicated below, Time Wamer's income (loss) per common share in 1998 has: been affected by certain significant nonrecurring items. These items consisted of gains and losses relating to the sale or exdiange of various cable television systems and other investment-related activity and the effect of redeeming Time Warner's Series M Preferred Stock The aggregate net effect of these items in 1998 was to increase (decrease) income per common share by $.03 in the second quarter of 1998, and ($.28) in the fourth quarter of 1998, thereby aggreyating $(.25) per common share for the year. (b) Time Warners equity in the pretax income (loss) of the Entertainment Group for 1998 includes net gains of approximately $g0 miilion for the year relating to the sale or exchange of certain cable television systems, of which approximately $70 million was recorded in the second quarter ot 1998. In addition, Time Warner's equity in the pretax income (loss) of the Entertainment �roup for the fourth quarter of 1998 includes a charge of approximately $210 million principally to reduce the carrying value of an interest in Primestar. (c) Time Warner's income (loss) per common share in 1997 has been affected by certain significant nonrecurring items. These items consisted of net pretax gains relating to the sale or ezchange of various cable television systems and other investment-related activity and e,ctraordinary losses on the retirement of debt The aggregate net effect of these items in 1997 was lo increase (decrease) income per common share by $.13 in the first quarter of 1997, $(.01) in the third quarter of 1997 and $.15 in the fouRh quaRer of 1997, thereby aggregaling $.27 per common share for the year. Included in these amounts are eztraordinary losses on the retirement of debt of $17 million ($.02 per common share) in the lirst quaAer of 1997, $7 million ($.01 per common snaie) in the thvd quarter of tg97 and $31 million ($.02 per common sharel in the fourth quarter of 1 ggZ Also included in these amounts for the fourth quarter of 1997 is a$200 milhon pretax gain ($.70 per common share) relating to the disposa! of Time Wamer's interest in Hasbro and its related redemption of certa�n mandatorily redeemable pre(erred secur�Ues of a subs�d�ary. (d) Time Warner's equity in the pretax income of the Entertainment Group for the first quarter of 1997 �ncludes an approz�mate $250 million pretax gain relating to the sale of TWE's interest in E! Entertainment Time Warners equity in the pretax income of the Entertainment Group for 7997 also includes net gains of approximately $200 million for the year relating to the sale or ezchange of certain cable lelevis�on systems, of which approz�mately $160 miliian was recorded in the fouRh quarter of 1997. (e) Aker preferced dividend requirements Preferred dividend requi�emenis for the fourth quaAer of 1998 �nclude a one-time increase oi $234 mill�on ($.19 loss per common share) relating to the premium paid in connection with the redempt�on of Time Warner's Series M Preferred Stock. (� Per common share amounts tor the Quarters and (ull years have each been calculated separately. Accordmgly, quarterly amou�ts may not add to the annual amounts because of differences in the average common shares outstanding during each period and, with regard to diluted per common share amounts only, because of the indusion of the effect of potentially ddutive securities only in the penods in which such effect would have been dlutive. (g) Previously reported amounts have been reslated for the two-for-one common stock spl�t Mat occurred on pecember 15, 1998. iiMF wARNFR INC 19i1tl ANNUAI RFI'Ul2T 9S CORPORATE MANAGEMENT GROUP Gerald M. Levin Richard J. Bressler Chairman and Executive vice President and Chief Executive Officer Chief Financial Officer R.E Turner Peter R. Haje �ce Chairman Executive Vice President, Richard D. Parsons General Counsel and Secretary President BOARD OF DIRECTORS Gerald M. levin Chairman and CEO, Time Warner Inc. R.E Turner Vice Chairman, Time Warner Inc. Richard D. Parsons President, . Time Warner Inc. Merv Adelson Chairman, East-West Capital Associates J. Carter Bacot Retired Chairman and CEO, and Director, The Bank of New York Company, Inc. Stephen F. Bollenbach President and CEO, Hilton Hotels Corporation . John C. Danforth Former U.S. Senator, and Partner, Bryan Cave LLP Beverly SiIIs Greenough Chairman, Lincoln Center for the Performing Arts Gerald Greenwald Chairman and CEO, UAL Corporation and United Airlines OPERATING OFFIGERS . .. __. _ .. .. Cable Networks Home Box Office Jeffrey �. Bewkes Chairman and CEO Turner Broadcasting System, Inc. Terence F. McGuirk Chairman and CEO Steven J. Heyer President and C00 CNN News Group W. Thomas Johnson Chairman, President and CEO New Line Cinema Robert K. Shaye Chairman and CEO Michael Lynne President and C00 9F) TIMC VlARNE'R INC. 1998 ANNUl�L REPORT Publishing Time Inc. Don Logan Chairman and CEO Norman Pearlstine Editor-In-Chief Entertainment Warner Bros. & Warner Music Group Robert A. Daly Chairman and Co-CEO Terry S. Semel Chairman and Co-CEO Barry M. Meyer Executive Vice President and C00. Warner Bros. Timothy A. Boggs Senior Uce President Andrew J. Kaslow Senior Yce President Human Resources John A. LaBarca Senior vice President and Controller Ambassador Carla A Hills Chairman and CEO, Hills 8� Company, and former United States Trade Representative Reuben Mark Chairman and CEO, Colgate-Palmolive Company Michael A Miles Former Chairman and CEO, Philip Morris Companies Inc. Francis T. Vincent, Jr. Chairman, Vincent Enterprises Cable Systems Time Warner Cable Joseph J. Collins Chairman and CEO Glenn A. Britt President Thomas M. Rutledge Senior Executive Vice President Board of Directors Seated, left to right: Beverly Sills Greenough, Gerald Greern•;�Id. Merv Adelson, Francis T. Vincent, Jr. Middle row, leff to right: Reuben Mark, Richard D. Parsons, Gerald M. Levin, R.E. Turner, Carla A. Hill; Back row, IeR to right: Stephen F. Bollenbach, J. Carter Bacot. John C. Danforth, Michael A. Miles . 11MI'_ WAHN[R INC 195_ r.\\'Up.L REpC=.- 9% Investor Information Common Stock Time Warner common stock is listed on the New York St�ck Exchange under the ticker symbol "TWX." As of December 31, 1998, there were approximately 1.2 biliion shares•of common stock outstanding (including a special class of common stock). 1998 Stock Price High: $63.1250 Low: $29.0625 Close (12/31/9A1; $62.0625 Dividend payments on common stock are made quarterly following declara- tion by the Board of Directors. Shareholder Inquiries Shareholder inquiries regarding stock transfers, dividend payments, account changes., lost stock certificates, the Dividend Reinvestment Plan or other account services should be directed to the Transfer Agent at the address or telephone number listed below: ChaseMellon Shareholder Services 85 Challenger Road Ridgefield Park, NJ 07660 (800) 279-1238 Annual Meeting of Shareholders The Annual Meeting of Shareholders will be held on Thursday, May 20, 1999, at 10:00 a.m. at Warner Bros. Studio, 4000 Warner Boulevard, Burbank, California Dividend Reinvestment Plan The Dividend Reinvestment and Stock Purchase Plan provides registered owners of common stock with a con- venient and economical way to purchase additional shares of Time Warner's common stock. Please contact ChaseMellon Shareholder Services at (800) 279-1238 for more information. Independent Auditors Ernst & Young LLP Fixed Income Inquiries For information regarding the fixed income securities of Time Warner, Time Warner Companies or Turner Broadcasting System, please contact the Trustee, The Chase Manhattan Bank, c% Chase Bank of Texas, at (800) 275-2048. For information regarding the 8.87.5% Preferred Trust Securities of Time Warner Capital, please contact the Trustee; First National Bank of Chicago, at (800) 524-9472. For information regarding the fixed income securities of Time Warner Entertainment Company, please con- tact the Trustee, The Bank of New York, at (800) 507-9357. Photo Credits . cna�e NeTworrKS: The Sopranos: Anthony Neste/HBO; Lost In Space: Jack Engi�sh/New L�na; Intruducmy Dorolhy Dandridge: S�dney Baldwin/HBO; Oscar De La Hoya: Holly Ste�n/HBQ; CNN Newsroom� Kyle Chnsty; Rush Houc ^ Bob Marshak/New Line; Smoltz: �%Chns Hamilton; Purgatory: Gregory Heisler. WCW Thundcr J. Stoll, On Thc Tnw�� . 'c.19a9 Tumer Entertamment Co.; � pr:reRrniNmeNr: Lethal Weapon 4: Andrew Cooper; You've Got Mail� Bnan Hanu!; Busta Rhyn,cs� Dean K:��r, Morchccb❑. � Michelle Simon; Laura Pausini: Pabnzio Fern; Barenaked Latl�es� Jay Blakesbery. Thrtd Lye E3hnd 11l�son Dycr. Jewel: � Matthew Rollston; Madonna: Mano Teshmo; 8randy: Reis�y & Taylor CnB�E S�5rEM5�, Inleractive Program Gwde: Wmchell photo-Lorey Sebaslian/HBO Corporate Publications Copies of Time Warner's annual report on Form 10-K, quarterly reports on Form 10-Q, Annual Report to Shareholders and Community Responsibility Report are available free of charge by writing or calling: Shareholder Relations Time Wamer Inc. 75 Rockefeller Plaza New York, NY 10019 (212) 484-6971 Time Warner's Internet Home Page Corporate news releases, recent publications, access to Time Warner's content sites and other company infor- mation can be found on Time Warner's Internet site at www.timewarner.com Time To Read Time To Read, Time Warner's award- winning volunteer literacy initiative, trains employee and community volun- teers to tutor children and adults who want to improve their reading, writing and comprehension skills. Detailed information may be obtained by calling (212) 484-6410 or by visiting the Web site at www.timewarner.com/ttr Corporate Headquarters Time Warner Inc. 75 Rockefeller Plaza New York, NY 10019 (212) 484-8000 �' 1999 T�me Wamer Inc Eaecutive Portrait Photography T�mothy Greenlictd-Sande�s Produd Photography Jody Dole: Ashton Worth�nql;in Printing The Henneyan Company. Fio:c,u,• KY Design frank(u�t Balkin�l NY/I �/SF Time Warner at a Glance Cable Net��vorks Home Box O�ce HBO HBO Plus HBO Signature HBO Family HBO Comedy HBO Zone Cinemax MoreMAX ActionMAX ThrillerMAX HBO en Espanol Joint Ventures Comedy Central HBO Ole and Brasil HBO Asia H80 Central Europe � Turner Broadcasting CNN CNN Headline News CNN International CNNfn CNN/Sports lllustrated CNN en Espanol CNN Airport Network CNNRadio CNN Radio Noticias CNN Interactive TBS 5uperstation Turner Network Television Cartoon Network Turner Classic Movies TNT Europe Cartoon Network Europe TNT Latin America Cartoon Network Latin America TNT & Cartoon Network/Asia Pacific Atlanta Braves Atlanta Hawks Atlanta Thrashers World Championship Wrestling Goodwill Games Jornt Venture Cartoon Network .1apa� Court N (TWE-owned) . New Line Cinema New Line Cinema Fine Line Features New Line Home Vdeo New Line international New Line Television Publislli»� Time Inc. Time People Sports Illustrated Fortune Life Money Parenting In Style Entertainment Weekly Cookin9 Light Baby Talk First Moments Coastal Living Health People en Espanol Progressive Farmer Southem Accents Southem Living Sports illustrated For Kids Sunset Teen People This Old House Time for Kids Weight Watchers Mutual Funds Your Company Asiaweek Dantyu President Walipaper Who Weekly Time Life Inc Book-of-the-Month Club Warner Books Little, Brown and Company Oxmoor House Leisure Arts Sunset Books Media Networks inc. Time Inc. Custom Publishing Time Inc. New Media Time Distribution Services Warner Publisher Services Entertainment Warner Bros. Warner Bros. Pictures Warner Bros. Television Warner Bros. Television Animation Looney Tunes Hanna-Barbera Castle Rock Entertainment Telepictures Productions The WB Television Network Kids' WB! Warner Home vdeo Warner Bros. Consumer Products Warner Bros. Worldwide Licensing Wamer Bros. Studio Stores Warner Bros. International Theatres Warner Bros. Recreation Enterprises Warner Bros. Online DC Comics MAD Magazine Wamer Music Group The Atlantic Group Elektra Entertainment Group Rhino Entertainment Sire Records Group Warner Bros. Records Warner Music International Wamer/Chappell Music Warner Bros. Publications WEA Inc. WEA Corp. WEA Manufacturing Ivy Hill Corp. Warner Special Products Alternative Oistribution Alliance Giant Merchandising Joint Ventures Columbia House 143 Records Maverick Tommy Boy Music �west Cable Systems Tme Wamer Cable Clusters of more tha� 100,000 subscribers at December 31, 1998 __._._..... --___.....------._........._..........._ ............................ ...................... ......... ... Divisions/Clusters Subscribers (Thousands) __............_...._._ ........................................................ ................_ .................. .._. ..... New York City 1,160 Tampa Bay �gg Houston 654 Central Florida 573 Raleigh/Fayetteville 430 Milwaukee 376 Charlotte 360 Austin/Waco 358 Los Angeles 349 Greensboro 336 Syracuse 314 Kansas City, MO 307 San Antonio 301 Rochester 301 Columbia, SC 2g$ Northeast Ohio 298 Hawaii 297 Cincinnati 248 Albany 243 Boston 240 Columbus 237 San Diego 232 Memphis 225 Minneapolis � gg Eastern Pennsylvania 153 Green Bay 144 Wilmington 7 38 Chicago 133 Portland, OR 130 Western Ohio 128 Indianapolis 121 EI Paso 1 1 g Jackson/Monroe, MS 1 1 1 Joint Venfures Road Runner Time Warner Telecom, LLC Substantially all of the assets of Home Box Office and Warner Bros. and most of the cable systems shown above are held in Time Warner Entertainment Company, L.P, T�me Warner owns 74.49% of the residual equity and certain pnority interesis of TWE. A portion of the cable systems are held �n a parinership of wh�ch approximately two-thirds is owned by TWE. ■ _.—. c � m www.timewarner.com ■ ■ ■■ ■ c■ � :.� �-��■ � � ■��e �� , C&L^.. ■ C ■ � iZ■' Pc Q E ■� � E. ■ ■�� G� ■ P,. � ■ ■ � �G. ■ �� ■@�C6G ■�e��, � ■e�E' % �� E � ■ ■' �' � C' �� C; ■�¢ ` � �C■ � F: ■E�S E � ■ F��•E7 0 C ■ ■� ■� ■� � 6 ■■ ■■ ��■ F ■ ■ � ■ ■ ■ ■ ■ �� a o � ■■ � ��x ■ � �! e�■ �:�� a ■ s� i: ■ ■ ■s ■ ■ �� ■ ■ s ■ � e. �_ F � f;. ■ ■ � r SECURITIES AND EXCHANGE COMMISSION Washington, D. C. 20549 FORM 10-Q [ x] QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT of 1934 for the quarterly period ended September 30. 1999, or [] TR.ANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF TI-iE SECURIT`IES EXCHANGE ACT of 1934 for the �ansition period &om to Commission file number 1-12259 TIME WAatNER INC. (Exact name of regisuant as specified in its charter) Delaware 13-3527249 (State or other jurisdicrion of (I.RS. Employer incorporatioa or organiTation) Identification Number) 75 Rockefeller Plaza New York, New York 10019 (212)484-8000 (Address, iacluding zip code, and telephone aumber, iacluding area code, of regis�ant's principal executive offices) Indicate by check mazk whether the regis�aat (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes x No Indicate the number of shac+es ontstanding of each of the issuet's classes of common stock, as of the latest practicable date. � Common Stock -$.O1 par value 1,172,397,199 Series LMCN-V Co�non Stock -$.Ol paz value 114.123.884 Description of Class Shares Ouutanding as of October 31, 1999 TIME WARNER INC. AND TIME WARI�IER ENTERTAINMENT COMPANY, L.P. INDEX TO FORM 10-Q PaQe Time Warner TWE PART I. FINANCIAL INFORMATION Management's discussion and analysis of results of operarions and financial condition.......... 1 38 Consolidated balance sheet at September 30, 1999 and December 31, 1998 ........................... 17 48 Consolidated statement of operations for the three and nine moaths ended September 30, 1999 and 1998 .......................................................................................... 18 49 Consolidated statement of cash flows for the nine months ended September 30, 1999 and1998 ........................................................................................................................... 19 50 Consolidated statement of shareholders' equity and parniership capital .................................. 20 51 Notes to consolidated financial statements ............................................................:.................. 21 52 Supplementaryinformarion ...................................................................................................... 30 PART II. OTHER INFORMATION ........................................................................................... 58 TTME WARNER INC. MANAGEMENT'S DISCUSSION AND ANALYSIS OF RESULTS OF OPERATIONS AND FINANCIAL CONDITION Description of Business Time Warner Inc. ("Time Wamer" or the "Company") is the world's lugest media and entertainment company. Time Warner's principal business objective is to create and dis�ibute branded informarion and entertainment copyrighu throughout the world. Time Wamer classifies its business interesu into five fundamental areas: Cable Networks, consisting principally of interests in cable television programming; Publishing, consisting principally of interests in magazine publishing, book publishing and direct marketing; Music, consisung principally of interests in recorded music and music publishing; Filmed Entenainment, consisting principally of interests in filmed entertainment, television production and television broadcasting; and Cable, consisting principally of interesu in cable television systems. Investmeat in TWE A majority of Time Warner's interesu in filmed entertainment, television productioq television broadcasting and cable television systems, and a portion of its interests in cable television programcning, are held through Tune Wamer Entertainment Company, L.P. ("TWE"). Time Waraer owns general and limited partnership interests in TWE consisdng of 74.49% of the pro rata priority capital ("Series A Capital") and residual equity capital ("Residual Capital"), and 100% of the junior prioriry capital. The remainiag 25.51 % limited parniership interests in the Series A Capital and Residual Capital of TWE aze held by a subsidiary of MediaOne Group, Inc. ("MediaOne"). Siace 1993, Time Warner historically had not consolidated TWE and certain related companies (the "Entertainment Group") for financial reporting purposes because MediaOne had rights that allowed it to participate in the management of TWE's businesses. However, in August 1999, TWE received a notice &om MediaOne concerning the temunation of its covenant not to compete with TWE. The termination of that covenant is necessary for MediaOne to complete its proposed merger with AT&T Coip. ("AT&T"). As a result of the termination notice and the operation of the TWE parhiership agreemcnt, MediaOne's rights to participate in the management of TWE's businesses terminated urnnediately and irrevocably. MediaOne retains only certain protective governance rights pertaining to certain limited matters affecting TWE as a whole. Because of this significant reduction in MediaOne's rights, Tune Warner has consolidated the Entertainment Group, which substantially consists of TWE, in its 1999 financial statements, re�oactive to the beginning of 1999. The proposed merger of MediaOne and AT&T is subject to customary closing conditions, including regulatory approvals. Accordingly, there is no assurance that it will occur. Also, there are no assurances that AT&T and Time Warner will reach final agreement on the Lermc of a cable telephony joint venwre, either on the terms discussed on page F-17 of Time Warner's Anaual Report on Form 10-K for the year ended December 31, 1998, as amended, or on any alternative terms. Columbia House-CDNOW Merger In July 1999, Time Wazner announced an agreement with Sony Coiporation of America ("Son�') to a�ecge their joindy owned Columbia House operations with CDNOW, Inc. ("CDNOW'), a leading music and video e-co�erce company. Ti�e Waraer and Sony will each own 37% of tbe combinod cntity and the existing CDNOW shareholdecs will own 26% of the combined entiry. T'his mvesuneat is expected W be accounted for using the equity method of accounting. With a combiaed reach of approximately 10% of all domestic Intemet users�t�, the combined entity is expected to create a significant platform for Time Warner's music and video e-cou�nterce initiarives and position the Company �� As meazwtd by Modia Metrix, Inc. as of September 1999. TIME WARNER INC. MANAGEMENT'S DISCUSSION AND ANALYSIS OF RESULTS OF OPERATIONS AND FINANCIAL CONDITION—{Continued) for incremental growth opportuniries relating to online sales of music and video product and the digital disti-iburion of music. In addition, management believes that the use of Columbia House's existing acrive club members and the cross- promorional opportunities to be offered by Time Wamer and Sony will lower customer acquisirion costs and increase the combined entity's customer base. As part of this transaction, Time Wamer and Sony each have made certain s�ategic and financial commiunents to the combined entity. Among the strategic commitinenu, which have a term of five years and aze subject to certain condirions and qualifications, Time Wamer and Sony will provide the combined enrity with opportunities to purchase advertising and promorional support from their diverse media properties. In addition, as part of their commitment to make the combined entiry their primary vehicle to pursue the packaged music e-commerce business, Time Warner and Sony will link their own music-controlled web sites in the U.S. and Canada to the combined entity's web sites. This will enable consumers to sample content from their favorite ardsts and genres and then ir�nediately make a purchase. Further, Time Warner and Sony have each agreed to guarantee, for up to a three-yeaz period, one-half of the borrowings under a new credit faciliry to be entered into by the combined enrity upon the closing of the merger. The credit facility is expected to provide for up to $450 million of boaowings, wlrich will be used to support the ongoing growth and capital needs of the business and to refinance approximately $300 million of existing debt and liabilities of Columbia House. The merger is expected to close in late 1999 or early 2000 and is subject to customary closing condirions, including regulatory approvals and approval by existing CDNOW shareholders. There can be no assurance that such approvals will be obtained. Use of EBITA Time Warner evaluates operating performance based on several factors, including its primary financial measure of operaring income before noncash amortization of intangible assets ("EBTTA"). Consistent with management's financial focus on con�olling capital spending, EBTTA measures operating perforn�ance after charges for depreciation. In additioq EBITA eliminates the uneven effect across all business segments of considerable amounts of noncash amortiZation of intangible assets recognized in business combinarions accounted for by the purchase method. 'I'hese business combinarions, including the $14 billion acquisirion of Warner Communicarions Inc. in 1989, the $6.2 billion acquisirion of Tumer Broadcasting System, Inc. ("TBS") in 1996 and the $2.3 billion of cable acquisitions in 1996 and 1995, created over $25 billion of intangible assets that generally are being amortized over a twenty to forty year period. The exclusion of noncash amortizarion charges is also consistent with management's belief that Time Warner's intangible assets, such as cable television and sports franchises, music catalogues and copyrights, film and television libtaries and the goodwill associated with its brands, generally are increasing in value and i�ortance to Time Warner's business objective of creatiag, extending and dish�ibuting recognizable brands and copyrighu throughout the world. As such, the following comparative discussion of the results of operarions of Time Wazner includes, among other factors, an analysis of changes in business segment EBITA. However, EBITA should be considered in addition to, not as a subsritute for, operating income, net income aad other measures of financial perforn�ance reported in accordaace with generally accepted accounting principles. Transactions Affecting Comparability of Results of Operations and Financial Condition Consolidation of the Entertainment Group As previously described, Time Wazner's 1999 operating results and financial condition reflect the consolidation of the Entertainment Group, which substantially consists of TWE, retroacrive to the beginning of 1999. Time Warner's 1998 historical operating results and financial condition have not been changed, but are no longer comparable to 1999 because the Entertainment Group was reflected on an unconsolidated basis using the equity method of accounting. Accordingly, in order to enhance comparability and make an analysis of 1999 and 1998 more meaningfiil, the following TIME WARNER INC. MANAGEMENT'S DISCUSSION AND ANALYSIS OF RESITLTS OF OPERATIONS AND FI1�iANCIAL CONDITION—(Continued) discussion of resulu of operations and changes in fmancial condition and liquidity is based upon pro fom�a financial informarion for 1998 as if the consolidation of the Entertainment Group had occurred at the beguuung of that period. Historical financial informarion of Time Warner for 1998 is inciuded in the accompanying consolidated financial statements. Other Significant Transactions and Nonrecurring Items As more fully described herein, the comparabiliry of Time Warner's operating results has been affected by certain other sigaificaat traasactions and nonrecurring items in each period. In 1999, these nonrecurring items consisted of (i) an approximate $215 million net pretax gain recognized in the first quarter of 1999 in connection with tbe early termination and settlement of a loag-term home video distribution agreement, (ri) an approximate $115 million pretax gain reco�ized in the second quarter of 1999 in connection with the initial public offering of a 20% interest in Time Warner Telecom Inc. (the `°7ime Warner Telecom IPO"), a coa�etitive local exchange carrier that provides telephony services to businesses, (rii) net pretax gains in the amount of S 1.248 billion recognized in the 5rst nine months of 1999 relating to the sale or exchange of various cable television systems aad investrnents and (iv) an ex�aordinary loss of $12 million reco�ized in the third quarter of 1999 relating to the retirement of debt This compares to net pretax gains recogaized in the fust nine months of 1998 of $90 million relating to the sale or exchange of cable television systems. In order to meaningfully assess uaderlying operating trends, management believes that the results of operations for each period should be analyzed after excluding the effects of these sigaif'icant nonrecurring items. As such, the following discussion and analysis focuses on amounts and �ends adjusted to exclude the impact of these unusual items. However, unusual items may occur in any period. Accordingly, iavestors and other financial statement users individually should consider the types of events and uansactions for which adjusunents have been made. In addition, the comparabiliry of Time Warner's Cable division results has been affected fiuther by certain 1998 cable-related ttansactions, as described more fully in Note 8 to the accompanying consolidated financial statements. While these transactions had a si�ificant effect on the comparability of the Cable division's EBITA and operating income principally due to the deconsolidation of the related operations, they did not have a si�ificant effect on the comparability of Time Warner's net income and per share resulu. 1998 Stock Sp1it Per common share and average common shaze amounu have been restated to give effect to a two-for-one common stock split that occurred on December 15, 1998. TIME WARNER INC. MANAGEMENT'S DISCUSSION AND ANALYSIS OF RESiJLTS OF OPERATIONS AND F'INANCIAL CONDITION—(Continued) RESULTS OF OPERATIONS EBITA and operating income are as follows: Cable Networks .................................... Publishing............................................. Music.................................................... Filmed Entertainment�b� ........................ Broadcasting-The WB Network ........... Cable�`� .................................................. Intersegment eliminarion ...................... Three Months Ended Seotember 30. IVine Months Ended Seotember 30 EBITA Ooeraene Income EBITA OoeraNne Income 1999 I998 1999 1998 1999 1998 1999 1998 His orical Pro Forma�'� Historical Pro Forma�'� Historical Pro Forma�'� Historical Pro Forma�'� (milliomj $ 328 $ 271 $ 277 $221 $1,003 $ 844 $ 851 $ 694 129 112 118 102 419 373 388 346 76 99 11 30 279 288 77 80 228 233 177 175 806 497 655 331 i24) �17) �25) �17) �95) ��g) �98) �80) 894 417 752 269 2,477 1,246 2,068 798 _L) �) 123) L) _L) �) �o) �76) Tota1 ...................................................... �� $1 � $1 Z � � � � 1 � � (a) Time Wamer's 1999 operadng rssults rcflect the consolidaoon of the Entertainmrnt Group, which substantially consists of TWE, reanactivc to the beginning of the year. Pro fomia operating results for 1998, reflaeng only the consolidation of the Enurtainment Group and not adjusting for the effecu of other aansactions and nonrecurring items discussed separately haein, are presented in order to rnhance comparability. Time Wamer's histmical EB1TA and operating income for 1998, which exclude the unconsolidated operadng results of the Entertainmrnt Group, were $516 million and 5315 million, respectively, far the third quarter and S1.468 billion and 5869 million, respectively, for the first nine months of the year. (b) Includes a net pretax gain of approximauly $215 million rscogniud 'm the first quatter of 1999 m connecaon with the early termination and settlement of a long-tem� home video disnibuAOn agreement. (c) Includes net pretax gains relaud W the sale or exchange of certain cable ulevision sysums and investrnrnu of $47� million in the third quarter of 1999 and $6 million in 1998. Similazly, nine-month results include net pretax gains of $1.248 billion in 1999 and $90 million in 1998. Three Months Ended September 30, 1999 Compared to Three Months Ended September 30, 1998 Coasolidated Results Time Warner had revenues of $6.723 billion, income of $381 million before an extraordinary loss on the retirement of debt and net income of $369 million for the three months ended September 30, 1999, compared to revenues on a pro forma basis of $6.593 billion and net income of $39 million for the three months ended September 30, 1998. After preferred dividend requirements, Time Warner had basic income per com�n share before the ex�aordinary item of $.29 in 1999, and $.28 after, compazed to a net loss of $.03 per common share in 1998. On a diluted basis, income per common share before the ex�aordinary item was $.28 in 1999, and $.27 after, coa�azed to a net loss of $.03 per common share in 1998. As previously described, in addition to the consolidation of the Entertainment Group re�oacrive to the beginning of 1999, the comparability of Time Waraer's operating results for 1999 and 1998 has been further affected by certain significant, nonrecurriag items recognized in each period. These nonrecurring items consisted of approximately $477 million of net pretax gains in 1999, compazed to $6 million of net pretax gains in 1998. In addirion, net income in 1999 included an ex�aordinary loss on the retirement of debt of $12 million. The aggregate net effect of these items in 1999 was an increase in basic net income per common share of $.20. On a diluted basis, the aggregate net effect of these items in 1999 was an increase in basic net income per common share of $.19. The 1998 gains had no significant impact on per share results. Time Warner's net income increased to $369 million in 1999, compazed to $39 million in 1998. However, excluding the significant effect of the nonrecurring items referred to eazlier, net income increased by $75 million to $110 million in 1999 from $35 million in 1998. As discussed more fully below, this improvement principally resulted from an overall increase in Time Warner's business segment operating income and lower losses from certain investments accounted for under the equity method of accounting, offset in part by lugher interest expense principally in connection with borrowings used to redeem Time Wamer's Series M exchangeable preferred stock ("Series M Preferred Stock") 4 TIlVIE WARNER INC. MANAGEMENT'S DISCUSSION AND ANALYSIS OF RESITLTS OF OPERATIONS AND FINANCIAL CONDITION—(Continued) in December 1998 and higher income taxes due to the increase in Time Wamer's income. Similarly, excluding the aggregate effect of these nonrecumng items, normalized basic and diluted net income per common share increased to $.08, compazed to a normalized net loss of $.03 per common share in 1998. In addirion to the factors discussed above, the improvement in 1999 normalized per share results reflecu a$67 million reducrion in prefeaed dividend requirements principally relating to the redemption of Series M Prefeaed Stock in late 1998. The relationship between income before income taxes and income tax expense of Time Warner is principally affected by the amortization of goodwill and certain other financial statement expenses that are not deductible for income tax purposes. Income tax expense of Time Warner includes all income taxes related to iu allocable share of partnerstup income and its equiry in the income tax expense of corporate subsidiaries of the Entertainment Group. Business Segment Results Cable Nerworks. Revenues increased to $1.450 billion in 1999, compared to $1.330 billion on a pro forma basis in 1998. EBITA increased to $328 aullion in 1999 from $271 million on a pro forma basis in 1998. Operating income increased to $277 million in 1999 from $221 million on a pro forn�a basis in 1998. Revenues grew due to increases at the Tumer cable networks group and HBO. For the Turner cable networks group, revenues benefited from increases in adverasing and subscriptioa revenues, offset in part by the absence of reve�es from the Goodwill Games sponsored in the suimmer of 1998. The increase in advertising reveaues was principally due to a s�ong overall advertising market for most of the group's networks, including CNN, TBS Superstation, TNT and Cartoon Network. The increase in subscription revenues was principally due to an increase in subscriptions and higher rates, primarily led by revenue increases at CNN, TBS Superstarioq TNT and Tumer Classic Movies. For HBO, revenues benefited primarily from an increase in pay-televisioa subscriptions. Likewise, EBITA and operating inco� were higher due to iacreases at the Turner cable networks group and HBO. For the Turner cable networks group, the increase in EBITA and operating income was principally due to the revenue gains and the absence of losses associated with the Goodwill Games, offset in part by higher programming cosu. For HBO, the iacrease in EBITA and operating income was principally due to the revenue gains and increased cost savings. . Publishing. Revenues imcreased to $1.110 billion in 1999, compared to $1.076 billion in 1998. EBITA increased to $129 million in 1999 from $112 million ia 1998. Operating income increased to $118 million in 1999 from S 102 million in 1998. Revenues ia 1999 were affected aegatively by the deconsolidation of a direct-marketing operation, which is now being accounted for uader the equity method of accouating. Fxcluding d�is change, revenues increased primarily from significant growth ia magazine advertising revenues, as well as iacreases in magazine circulation revenues. The increase in adverasing reveaues was principally due to a strong overall adverdsing mazket for most of the division's magaziaes, primarily led by In Style, People, Sports Illustrated, Entertainment Weekly and Teen People. The increase in circulation revenues was principally due to higher newsstand sales, led by People and Time, offset in part by lower net subscription revenues generated by American Family Entecprises ("AFE'�, a 50%-owned equity investee, and other third-parry agencies. EBITA and operating income increased principally as a result of the revenue gains and increased cost savings. These incrcases were offset in part by the absence of certain one-dme gains on the sale of assets recognized in 1998 and lower results from direct-mazketing activities, including Book-of-the-Month Club and AFE. In additioq in October 1999, AFE voluntarily filed for Chapter 11 banlauptcy protecrion under the U.S. Banlauptcy Code. This action is expected to allow AFE to resolve its pending private litigation relating to its sweepstakes promotions and to res�ucture its operations and 5nances. Time Warner's management expects that the outcome of the banlavptcy proceedings will not be material to Time Warner's future operating results and financial condition. TIME WARNER INC. MANAGEMENT'S DISCUSSION AND ANALYSIS OF RESULTS OF OPERATIONS AND FINANCIAL CONDITION�Continued) Music. Revenues decreased to $852 million in 1999, compared to $938 million in 1998. EBITA decreased to $76 million in 1999 from $99 million in 1998. Operating income decreased to $11 million in 1999 from $30 million in 1998. Revenues decreased primarily due to lower domestic and interaarional recorded music sales. The worldwide revenue decline principally related to less popular releases in comparison to the prior year, as well as indusuy-wide sof�ess in various intemarional markets, like Brazil and Germany. EBITA and operating income decreased principally as a result of the decline in worldwide revenues and lower results from Columbia House, a 50%-owned equiry investee, offset in part by increased cost savings, lower aztist royalty costs and higher income from DVD manufacturing operations. Management expects that the revenue decline relating to lower worldwide sales levels will continue into the fourth quarter of 1999, which could continue to affect operating results negatively. Filmed Entertainment. Revenues decreased to $2.208 billion in 1999, compared to $2.272 billion on a pro forma basis in 1998. EBITA decreased to $228 million in 1999 from $233 million on a pro forma basis in 1998. Operating income increased to $177 million in 1999 from $175 million on a pro forma basis in 1998. Revenues decreased because revenue iacreases at Warner Bros. were more than offset by revenue declines at the Turner filmed entertainment businesses, which include New Line Cinema, Castle Rock Entertainmeat and the former film and television libraries of Metro-Goldwyn-Mayer, Inc. and RKO Pictures, Inc. For Warner Bros., revenues benefited from increases in worldwide theatiical, home video and television syndication operarions, offset in part by lower revenues from consumer producu operarions. The increase in worldwide home video revenues primarily resulted from increased sales of DVDs. For the Turner filmed entertainment businesses, revenues decreased principally as a result of the absence in 1999 of significant syndication revenues from the sale of second-cycle broadcasting rights for Seinfeld in 1998, and fewer and less popular third-quarter theatrical releases ia 1999. EBITA was lower and operating income was relarively flat because increases at Warner Bros. were either more than or substanrially offset by EBITA and operating income declines at the Turner filmed entertainment businesses. For Warner Bros., EBITA and operating income increased principally as a result of improved results from worldwide theatrical, home video and television syndicarion operations, offset in part by lower results from consumer pmducts operations. For the Turner filmed entertainment busiaesses, EBTTA and operating inco� decreased principally as a result of the decline in revenues, offset in part by lower participation cosu payable to crearive talent. In connecrion with declines in the operations of certain of Warner Bros.'s retail stores, management is in the process of evaluating several s�ategic alternarives for its retail operations. These alternarives include the gradual reducrion and updating of Warner Bros.'s store portfolio, including the �ansformation of some of the traditional retail oudets to smaller, more efficient stores and an increasing emphasis on e-commerce opportuniries. To the extent manage�nt takes action under some of these altemarives, a non-cash charge, principally relating to the acceleration of future depreciation expense, may be required. Management's evaluation is expected to continue through the 1999 holiday shopping seasoa. Broadcasting - The WB Network Revenues were $84 million in 1999, compazed to $64 million on a pro forma basis ia 1998. EBITA decreased to a loss of $24 million in 1999 from a loss of $17 million on a pro forma basis in 1998. Operating losses increased to $25 million in 1999 �om $17 million on a pro forma basis in 1998. Revenues increased principally as a result of one addirional night of weekly prime-rime programming in comparison to the prior year and advertising rate increases, offset in part by lower television ratings for the summer repeat prograaaning lineu�. Operating losses increased principally because the revenue gains were more than offset by the combination of higher progiamming costs associated with the expanded programming schedule and higher start-up costs associated with The WB Network 100+ station group, a dis�ibution alliance for The WB Network in smaller mazkets. Cable. Revenues increased to $1342 billion in 1999, coa�ared to $1.288 billion on a pro forma basis in 1998. EBTTA increased to $894 million in 1999 from $417 million on a pro forma basis in 1998. Operating income increased to $752 million in 1999 from $269 million on a pro forcna basis in 1998. These opera�ng results were affected by certain 6 TIME WARNER INC. MANAGEMENT'S DISCUSSION AND A1rALYSIS OF RESULTS OF OPERATIONS AND FTNANCIAL CONDITION--(Continued) cable-related transactions that occurred in 1998 (the "1998 Cable Transacrions") and by net pretax gains of $477 million recognized in 1999 and $6 million in 1998 related to the sa]e or exchange of vanous cable television systems and inves�nents. The 1998 Cable Transacrions principally resulted in the deconsolidation of certain operarions and aze described more fully in Note 8 to the accompanying consolidated financial statements. Excluding the effect of the 1998 Cable Transacrions, revenues increased due to growth in basic cable subscribers, increases in basic cable rates, increases in advertising and pay-per-view revenues and an increase in revenues from providing Road Runner-branded, high-speed onliae services. Similarly, excluding the ef%ct of the 1998 Cable Transactions and the one-tune gains, EBITA and operaring income increased priacipally as a result of the revenue increases, offset in part by higher programming costs. Interest and Other, Net. Iaterest and other, net, decreased to $490 million of expense in 1999, compazed to $508 million of expense on a pro forma basis in 1998. Interest expense increased to $376 million in 1999, co�ared to $358 million on a pro forma basis in 1998. Interest expense increased principally because of higher interest costs incurred in connection with the $2.1 billion of boaowings used to redeem the Company's Series M Preferred Stock in December 1998, offset in part by interest savings associated with the Company's 1998 debt reducrion efforts. Other expense, net, decreased to $114 million in 1999, compazed to $ I50 million on a pro fomoa basis in 1998. The decrease principally related to lower losses from certain investmenu accounted for under the equity method of accounting. Minority In[erest. Minoriry interest expense increased to $59 million in 1999, compazed to $53 million on a pro forma basis in 1998. Minority interest expense increased primarily due to the allocation of a portion of the net pretax gains relatiag to the sale or exchange of various cable television systems and investinenu owned by the TWE- Advance/Newhoase Partnership ("TWE-A/N'), a majority-owned parmership of TWE, to the minority owners of that partnership. Excluding the si�ificant effect of the gains recognized in 1999, minority interest expense decreased slightly in 1999 principally due to a higher allocation of losses to a minority pazmer in The WB Network. Nine Months Ended September 30,1999 Compared to Nine Months Ended September 30, 1998 Consolidated Results Time Wazner had revenues of $19.345 billion, income of $1.112 billion before an ex�aordinary loss on retirement of debt and net iacome of $1.100 billion for the nine months ended September 30, 1999, compazed to revenues on a pro forma basis of $18.977 billion and net income of $78 million for the nine months ended September 30, 1998. After preferred dividend requirements, Tia�e Wamer had basic income per co�non share before the ex�aordinary item of $.85 in 1999, and $.84 after, compazed to a net loss of $.13 per coaanon share in 1998. On a diluted basis, income per common share before the ex�aordinary item was $.82 in 1999, and $.81 after, compazed to a net loss of $.13 per common share in 1998. As previously described, in addition to the consolidation of the Entcrtainment Group re�oactive to the beginning of 1999, the comparability of Ti�e Waraer's openring results for 1999 and 1998 has been further affected by certain significant, nonrecurring items recognized in each period. These nonrecurring items consisted of approximately $1.578 billion of net pretax gains ia 1999, compared to $90 million of net pretax gains in 1998. In additioq net income in 1999 included an exhaordinary loss on the retirement of debt of $12 million. The aggregate net effect of these items was an increase in basic net incoa� per coa�mon share of $.64 in 1999. On a diluted basis, the aggregate net effect of these items was an increase of $.61 per common share in 1999, compared to an increase of $.03 per common share in 1998. Time Waraer's net income increased to $1.100 billion in 1999, compared to $78 million in 1998. However, excluding the significant effect of the no�ecurring items referred w eazlier, net iacome increased by $247 million to $284 million in 1999 from $37 million in 1998. As discussed more fiilly below, this imiprovement principally resulted from an oveiall iacrease in Time Waraer's business segment operating incac�, offset in part by higher equiry losses from 7 TIME WARNER INC. MANAGEMENT'S DISCUSSION AND ANALYSIS OF RESIJLTS OF OPERATIONS AND FINANCIAL CONDITION—{Continued) certain investinents accounted for under the equity method of accounting, higher interest expense principally in connection with borrowings used to redeem the Company's Series M Preferred Stock in December 1998 and higher income taxes due to the increase in Time Wainer's income. Similarly, excluding the aggregate effect of these nonrecurring items, normalized basic and diluted net income per common share increased to $.20, compared to a normalized net loss of $.16 per common share in 1998. In addition to the factors discussed above, the improvement in 1999 normalized per share results reflecu a$191 million reduction in preferred dividend requirements principally relating to the redemprion of Time Wamer's Series M Preferred Stock in late 1998. The relationship between income before income taxes and income tax expense of Tune Wamer is principally affected by the amortization of goodwill and certain other financial statement expenses that aze not deductible for income tax piuposes. Income tax expense of Time Wamer includes all income taxes related to its allocable share of partnership income and its equity in the income tax expense of corporate subsidiaries of the Entertainment Group. Business Segment Results Cable Nenvorks. Revenues increased to $4.425 billion in 1999, compared to $3.985 billion on a pro forma basis in 1998. EBITA increased to $1.003 billion in 1999 from $844 million on a pro forma basis in 1998. Operating income increased to $851 million in 1999 from $694 million on a pro forma basis in 1998. Revenues grew due to increases at the Tumer cable networks group and HBO. For the Tumer cable networks group, revenues benefited from increases in adverasing and subscriprion revenues, offset in part by the absence of revenues from the Goodwil] Games sponsored in the suaaner of 1998. The increase in advertising revenues was principally due to a strong overall advertising market for most of the group's networks, including CNN, TBS Superstarion, TNT, Cartoon Network and Headline News. The increase in subscriprion revenues was principally due to an increase in subscriptions and higher rates, primarily led by revenue increases at CNN, TBS Superstatioq TNT and Turner Classic Movies. For HBO, revenues benefited primarily from an increase in pay-television subscriptions. Likewise, EBTTA and operating income were higher due to increases at the Turner cable networks group and HBO. For the Turner cable networks group, the increase in EBITA and operating income was principally due to the revenue gains and the absence of losses associated with the Goodwill Games, offset in part by Irigher progiananing costs. For HBO, the increase in EBTTA and operating income was principally due to the revenue gains, increased cost savings, and higher income �om Comedy Central, a 50%-owned equity investee. Publishing. Revenues increased to $3.237 billion in 1999, compazed to $3.160 billion in 1998. EBITA iacreased to $419 million in 1999 from $373 million in 1998. Operating income increased to $388 million in 1999 from $346 million in 1998. Revenues in 1999 were aff'ecud negatively by the deconsolidation of a direct-mazketing operation, which is now being accounted for under the equity method of accounting. Excluding this change, revenues increased primarily from significant growth in magazine advertising revenues. The increase in advertising revenues was principally due to a strong overall advertising market for most of the division's magazines, primarily led by In Style, People, Time, Teen People and Sporu Illustrated. Magazine circulation revenues were flat principally because higher newsstand sales, led by Time aad In Style, were offset by lower net subscription revenues generated by AFE and other third-party agencies. EBTTA and operating income iacreased principally as a result of the revenue gains, increased cost savings and higher gains on the sale of assets. These iacreases were offset in part by lower results from direct-marketing activities, including Book-of-the-Month Club and AFE. In addirion, in October 1999, AFE voluntarily filed for Chapter 11 banlmiptcy protection under the U.S. BanlQUptcy Code. This action is expected to allow AFE to resolve its peading private litigation relating W its sweepstalces promotions and to res�ucture its operations and 5nances. Time Warner's management expects that the outcome of the banlmiptcy proceedings will not be material to Time Warner's future operatiag results and financial condirion. 8 TIME WARNER INC. MANAGEMENT'S DISCUSSION AND ANALYSIS OF RESULTS OF OPERATIONS AND FINANCIAL CONDITION�Continued) Music. Revenues decreased to $2.616 billion in 1999, compared to $2.731 billion in 1998. EBITA decreased to $279 million in 1999 from $288 million in 1998. Operating income decreased to $77 million in 1999 from $80 million in 1998. Revenues decreased primarily due to lower domesric and international recorded music sales. The worldwide revenue decline principally related to less popular releases in comparison to the prior year, as well as industry-wide sofiness in various international markets, like Brazil and Germany. EBTTA and operaring income decreased principally as a result of the decline in worldwide reveaues and lower results from Columbia House, a 50%-owned equiry investee, offset in part by increased cost savings, lower artist royalty costs and higher income from DVD manufact�ing operations. Management expecu that the revenue decline relating to lower worldwide sales levels will continue into the fourth quarter of 1999, which could contiaue to affect operating results negarively. Filmed Entenainment. Revenues decreased to $5.688 billion in 1999, compared to $5.790 billion oa a pro forma basis in 1998. EBITA increased to $806 million in 1999 from $497 million on a pro forma basis in 1998. Operating iacome increased to $655 million in 1999 from $331 million on a pro forma basis in 1998. Revenues decreased because revenue increases at Warner Bros. were more than offset by revenue declines at the Turner filmed entertai�nent businesses, wlrich include New Line Cinema, Casde Rock Entertam�nt and the foaner film and television librazies of Me�o-Coldwyn-Mayer, Inc. and RKO Pictures, Inc. For Warner Bros., revenues benefited from increases in worldwide theauical, home video and television dis�ibution operarions, offset in part by lower revenues from consumer products operations. The increase in worldwide hoa�e video revenues pria�arily resulted from increased sales of DVDs. For the Tumer filmed entertainment businesses, revenues decreased principally as a result of the absence ia 1999 of si�ificant syndication revenues from the sale of second-cycle broadcasting righu for Seinfeld in 1998 and fewer thea�ical releases in 1999. EBITA and operaring income were higher due to increases at Wazaer Bros. and the Tumer fil�ned entertainment businesses, including an approximate $215 arillion net pretax gain recognized by Warner Bros. in the first quarter of 1999 in connection with the eazly termination and settlement of a long-term ho� video dis�ibution agreement. Excluding the gain, Warner Bros.'s EBITA and operating income increased principally as a result of improved results from worldwide thea�ical, home video and television dis�ibution operations, offset in part by lower results from consumer products operations. For the Tumer filmed entertainment businesses, EBTTA and operating income increased principally due to the absence of film write-offs relating to disappointing results for thea�ical releases of Casfle Rock Entertainment in 1998, ofiset in part by lower results from television disu�►bution operarions relating to the absence in 1999 of significaat syndication sales of broadcasting rights for Seinfeld in 1998. In connection with declines in the operations of certain of Wazner Bros.'s retail stores, management is in the process of evaluating sevenl s�trategic altematives for its retail opetations. These alternatives include the gradual reduction and updating of Wazner Bros.'s store portfolio, including the �ansformation of some of the �adirionai retail oudeu to smaller, more efficient stores and an increasing emphasis on e-com�rce opportunities. To the extent management takes action under some of these alteraatives, a aon-cash charge, principally relating to the acceleration of future depreciation expense, may be required. Management's evaluation is expected to continue through the 1999 holiday shopping season. Broadcasting - The WB Network Revenues were $246 million in 1999, coa�azed to $170 million on a pro forma basis in 1998. EBITA decreased to a loss of $95 million in 1999 from a loss of $78 million on a pro forma basis in 1998. Operaring losses increased to $98 million in 1999 from $80 million on a pro forma basis in 1998. Revenues increased principally as a result of one additional night of weekly prime-time pmgramaning in comparison to the prior yeaz, improved television ntings and advertising rate increases. Operating losses increased principally because the revenue gains were more than offset by the combination of higher progra�ning costs associated with the expanded programming schedule and higher start-up costs associated with The WB Network 100+ station group, a disttibution alliance for The WB Network in smaller markets. 9 TIME WARNER INC. MANAGEMENT'S DISCUSSION AND ANALYSIS OF RESITLTS OF OPERATIONS AND FTNANCIAL CONDITION�Continued) Cable. Revenues decreased to $3.968 billion in 1999, cornpared to $4.015 billion on a pro forma basis in 1998. EBITA increased to $2.477 billion in 1999 from $1.246 billion on a pro forma basis in 1998. Operating income increased to $2.068 billion in 1999 from $798 million on a pro forma basis in 1998. These operating results were affected by the 1998 Cable Transactions and by net pretax gains of $1.248 billion recognized in 1999 and $90 million in 1998 related to the sale or exchange of various cable television systems and investments. The 1998 Cable Transactions principally resulted in the deconsolidation of certain operarions and are described more fully in Note 8 to the accompanying consolidated financial statements. Excluding the effect of the 1998 Cable Transactions, revenues increased due to gowth in basic cable subscribers, increases in basic cable rates, increases in adver[ising and pay-per-view revenues and an increase in revenues from providing Road Runner-branded, high-speed online services. Similarly, excluding the effect of the 1998 Cable Transactions and the one-time gains, EBITA and operating income increased principally as a result of the revenue increases, offset in part by higher programming costs. Interest and Other, Net. Interest and other, net, decreased to $1387 billion of expense in 1999, compazed to $1.410 billion of expense on a pro forma basis in 1998. Interest expense increased to $1.116 billion in 1999, compazed to $1.082 billion on a pro forcna basis in 1998. Interest expense increased principally because of higher interest costs incurred in connection with the $2.1 billion of boaowings used to redeem the Company's Series M Preferred Stock ia December 1998, offset in part by interest savings associated with the Com�pany's 1998 debt reduction efforts. Other expense, net, decreased to $271 million in 1999, compared to $328 million on a pro forma basis in 1998. The decrease principally related to the recognition of an approximate $115 million pretax gain in 1999 in connection with the Time Wamer Telecom IPO, offset in part by higher losses from certain inves�r►eats accounted for under the equity method of accounting. Minority Interest. Minority interest expense increased to $358 million in 1999, compared to $200 million on a pro forma basis in 1998. Minority interest expense increased primarily due to the allocarion of a portion of the net pretax gains relating to the sale or exchange of various cable television systems and investrnents owned by TWE-A/N to the minority owners of that partnership. Excluding the significant effect of the gains recognized in each period, minority interest expense decreased slightly in 1999 principally due to a higher allocation of losses to a minority partner in The WB Network. FINANCIAL CONDITION AND LIQUIDITY September 30, 1999 Financia! Condition At Septetnber 30, 1999, Ti� Warner had $17.8 billion of debt, $645 million of cash and equivalents (net debt of $17.2 billion), $1.2 billion of boaowings against future stock option proceeds, $575 million of mandatorily redeem- able preferred securities of subsidiaries and $8.8 billion of shareholders' equiry, compazed to $17.5 billion of debt, $529 million of cash and equivalenu (net debt of $17.0 billion), $895 million of borrowings against future stock option proceeds, $792 million of mandatorily redeemable preferred securities of subsidiaries and $8.9 billion of shareholders' equiry on a pro forma basis at December 31, 1998. Debt Refinancings In July 1999, Time Warner Co�anies, Inc., a wholly owned subsidiary of Time Waraer, redeemed all of its $600 million principal amount of Floating Rate Reset Notes due July 29, 2009. The aggregate redemprion cost of approximately $620 million was funded with boaowings under Time Wamer's bank credit agreement. In coffiection with this redemprion, an ex�aordinary loss of $12 million was recognized in the third quarter of 1999. 10 TIME WARNER INC. MANAGEMENT'S DISCUSSION AND ANALYSIS OF RESULTS OF OPERATTONS AND FINANCIAL CONDITION�Continued) Prefened Stock Conversion In July 1999, Time Warner issued approximately 46 million shares of common stock in connection with the conversion of all ouutanding 11 million shares of iu Series D convertible preferred stock. Because holders of Series D preferred stock were enritled to cash dividends at a preferenrial rate through July 1999, Time Wamer's historical cash dividend requirements will be reduced, going forwazd, by approximately $30 million on an annualized basis. Common Stock Repurchase Prograni In Jaauary 1999, Time Waraer's Board of Directors authorized a new comcnon stock repurchase program that allows the Company to repurchase, from rime to time, up to $5 billion of common stock. This program is expected to be completed over a three-yeaz period; however, actual repurchases in any period will be subject to market conditions. Along with stock opuon exercise proceeds and borrowings under Titne Wamer's $1.3 billion stock option proceeds credit faciliry, addirional funding for this program is expected to be provided by future free cash flow and financial capacity. During the first nine months of 1999, Time Warner acquired 243 millioa shares of its common stock at an aggregate cost of $1.636 billion. These repurchases increased the cunnilative shares piuchased under this and its previous common stock repurcbase program begun in 1996 to approximately 119.4 million shares at aa aggregate cost of $4.676 billion. Redemption of REIT Prejerred Stock In Mazch 1999, a subsidiary of TWE (the "REIT"') redeemed all of its shares of preferred stock ("REIT Preferred Stock") at an aggregate cost of $217 millioq which approximated net book value. The redemprion was funded with boaowings under TWE's bank credit agreement Pursuaat to its terms, the REIT Preferred Stock was redeemed as a result of proposed chaages to federal tax regularions that substaatially increased the likelihood tl�at dividends paid by the REI? or interest paid to the REIT under a mortgage note of TWE would not be fully deduchble for federal income tax purposes. Cash Flows During the 5rst nine months of 1999, Time Wamer's cash provided by operations amounted to $2.802 billion and reflected 54.879 billion of EBTTA, $905 million of noncash depreciation expense and $85 million of proceeds from Time Warner's asset seciuitization program, less $1.137 billion of mterest payments, $261 million of iacome taxes, $120 million of corponte expenses and $1.549 billion related to an aggregate increase in worldng capital requirea�ents, other balance sheet accoimts and no�ash items. Cash provided by operations of $1.844 billion on a pro forma basis for the first nine months of 1998 reflected $3.094 billion of business segment EBTTA, $983 million of noncash depreciation expense and $233 amillion of proceeds from Time Warner's asset securitization program, less $1.122 billion of interest payments, $200 million of inco�e taxes, $112 million of corporate expenses and $1.032 billion related to an aggregate increase in worldng capital requirements, other balance sheet accounts and noncash items. Cash used by investing activities was $1.392 billion in the 5rst nine months of 1999, coa�ared to $922 million on a pro forma basis in the fust nine months of 1998. This increase principally resulted from a$463 million decrease in investinent proceeds largely relating to the 1998 sale of TWE's remaining interest in Six Flags Entertainment Corporation. Capital expenditures increased to $1.532 billion in the first nine months of 1999, compazed to $1.440 billion on a pro forma basis in the first nine months of 1998. Cash used by financing activities was $1.207 billion in the fust nine months of 1999, compazed to $1.371 billioa on a pro forma basis in the first nine �nths of 1998. The use of cash in 1999 principally resulted from the repurchase of approximately 24.3 million shares of Time Warner co�on stock at an aggregate cost of $1.636 billion, 11 TIME WARNER INC. MANAGEMENT'S DISCUSSION A.�ID ANALYSIS OF RESULTS OF OPERATIONS AND FINANCIAL CONDITION---(Continued) the redemption of REIT Preferred Stock at an aggregate cost of $217 million and the payment of $226 million of dividends, offset in part by a$316 million increase in net boaowings, $335 million of borrowings against future stock oprion proceeds and $350 million of proceeds received principally from the exercise of e�loyee stock options. During the first nine months of 1998, on a pro forn�a basis, excluding additional borrowings that offset the noncash reducrion of $1.15 billion of debt relating to the conversion of iu zero-coupon convertible notes into common stock, Time Warner reduced debt by approximately $1.1 billion. Time Warner used proceeds from the borrowings associated with the conversion of its zero-coupon convertible notes, together with most of the $599 million of proceeds received from the exercise of employee stock oprions and $482 million of net borrowings against future stock oprion proceeds, to repurchase approximately 26.4 million shares of Time Warner common stock at an aggregate cost of $1.944 billion during the first nine months of 1998. Tirne Warner also paid $394 million of dividends in the first nine months of 1998. The decrease in dividends paid in 1999 reflects the effect of Time Warner's redemprion of its Series M Prefeaed Stock in December 1998 and the conversion of approximately 15 million shares of prefeaed stock into shares of common stock that also occurred during 1998. The assets and cash flows of TWE are res�icted by certain boaowing and parmership agreements and are unavailable to Time Warner except through the payment of certain fees, reimbursements, cash disti-iburions and loans, which are subject to limitations. Under its bank credit agreement, TWE is pemutted to incur addirional indebtedness to make loans, advances, distributions and other cash paymenu to Time Warner, subject to its individual compliance with the cash flow coverage aad leverage ratio covenants contained therein. Management believes that Time Watner's operating cash flow, cash and equivalents and addirional borrowing capacity aze sufficient to fund its capital and liquidiry needs for the foreseeable future without distribudons and loans from TWE above those permitted by existing agreements. Cable Capital Speading Time Warner Cable has been engaged in a plan to upgrade the technological capabiliry and reliabiliry of iu cable television systems and develop new services, which it believes will position the business for sustained, long-term growth. Capital spending by Time Warner Cable amounted to $1.107 billion in the nine months ended September 30, 1999, compazed to $1.149 billion in the nine months ended September 30, 1998. Cable capital spending is expected to approximate $450 million for the remainder of 1999. Capital spending by Time Warner Cable is expected to continue to be funded by cable operating cash flow. Filmed Entertainment Backlog Backlog represents the amount of future revenue not yet recorded from cash conu�acts for the liceasing of thea�ical and television product for pay cable, basic cable, network and syndicated television exhibition. Backlog for all of Tut�e Warner's filmed entertainment companies amounted to $3.153 billion at September 30, 1999, compazed to $2.934 billion on a pro forma basis at December 31, 1998 (including amounts relatiag to the licensing of film product to Time Warner's cable television networks of $1.144 billion at September 30, 1999 and $995 million at December 31, 1998). Because backlog generally relates to contracts for the licensing of theatrical aad television product which have already been produced, the recognirion of revenue for such completed product is principally only dependent upon the commencement of the availabiliry period for telecast under the ternu of the related licensing agreement. Cash licensiag fees aze collected periodically over the term of the related licensing agreements or on an accelerated basis using a$500 million securitization facility. The portion of backlog for which cash has not already been received has significant off- balance sheet asset value as a source of future funding. The backlog excludes adverasing barter con�acts, which aze also 12 TIME WARNER INC. MANAGEMENT'S DISCUSSION AND ANALYSIS OF RESULTS OF OPERATIONS AND FINANCIAL CONDITION-�Continued) expected to result in the future realization of revenues and cash through the sale of advertising spots received under such con�acu. Year 2000 Technology Preparedness Time Warner, like most lazge companies, depends on many different computer systems and other chip-based devices for the continuing conduct of its business. Older co�uter programs, computer hardware and ctrip-based devices may fail to recognize dates beginning on January 1, 2000 as being valid dates, and as a result may fail to operate or may operate improperly when such dates aze in�oduced. Time Warner's exposure to potential Yeaz 2000 problems arises both in technological operarions under the con�ol of the Company and in those dependent on one or more third parties. These technological operations include information technology ('TT") systems and non-IT systems, including those with embedded technology, hardware and softwaze. Most of Time Warner's potential Year 2000 exposures are dependent to some degree on one or more third parties. Failure to aclueve high levels of Year 2000 compliance could have a material adverse im�act on Time Warner and its financial statemenu. The Compan�s Year 2000 initiative conrinues to be conducted at the operarional level by divisional project managers and senior technology executives overseen by senior divisional executives, with assistance intemally as well as from outside professionals. The progress of each division through the different phases of remediation—inventorying, assessment, remediation planniag, implementation and final testing—is actively overseen and reviewed on a regular basis by an execurive oversight group that reports through the Company's Chief Financial Officer to the Audit Committee of the Board of Directors. The Cor�any initially identified and assessed potenrial Year 2000 difficulties in its technological operations, including IT applications, TI' teclmology and support, desktop hardware and software, non-TT systecns and icr�ortant third party operations, and distinguished those that are "mission critical" from those that are aot. An item is considered "mission critical" if iu Year 2000-related failure would significandy impair the ability of one of the Company's major business units to (1) produce, market and distribute the products or services that genente significant revenues for that business, (2) meet its obligarions to pay its employees, aztists, vendors and others or (3) meet its obligations under regulatory requiremenu and internal accounting controls. The Company a� its divisions have ideatified approximately 1,000 worldwide, `�ission crirical" potential exposures. As of September 30, 1999, substantially all of these potenrial exposures have been idenrified by the divisions as Year 2000 compliant and of those that ar�e not rcported as compliant, substantially all were in 5aa1 testing stages and expected to be substantially completed in all material respects by the middle of the fo�rth quarter of 1999. The Compaay, however, could experience unexpected delays. The Company is expecting to focus its attention during the fourth quarter of 1999 on conducting final integrated testing in a stable environment and on refineasenu and testing of its contingency and �ansirion plans, as necessary. As stated above, however, the Company's busi�ss is heavily dependent on third parties, both domestically and internarionally, and these parties are themselves heavily dependent on technology. For exa�le, if a television broadcaster or cable pmgtammer encouaters Year 2000 problems that ia�ede iu ability to deliver its programming, the Company will be unable to provide tl�at progcamming to its cable customers. Because the Company is also a programming supplier, third-party signal delivery problems would affect its ability to deliver its pmgra�ing to iLs customers. In addition, in a situation endemic to the cable industry, �ch of the Company's headend equipment that con�ols cable set-top boxes needed to be upgraded to beco�e Year 2000 compliant. T'he box manufacturers and cable indus�y groups together developed solutions that the Company has substantially completed installing and testing in its headend equipment at its various geograpluc locations. The Company has attempted to include in its "mission critical" inventory significant service providers, vendors, suppliers, customers and governmental enrities that aze believed to be critical to busiaess operarions and has made its deteaninations of their state of Year 2000 readiness through various 13 TIME WARNER INC. MA1rAGEMENT'S DISCUSSION AND ANALYSIS OF RESULTS OF OPERATIONS AND FINANCIAL CONDITION—(Continued) means, including quesrionnaires, interviews, on-site visits, system interface testing and industry group participarion. The Company continues to monitor these situarions. Moreover, Tune Warner is dependent, like all large companies, on the continued functioning, domestically and internationally, of basic, heavily computerized services such as banking, telephony, water and power, and various dis�iburion mechanisms ranging from the mail, railroads and trucking to high- speed data transmission. Time Warner is taldng steps to atterr�t to sarisfy itself that the third parties on which it is heavily reliant are Year 2000 compliant, are developing sarisfactory contingency plans or that altemate means of ineeting its requirements aze available, but cannot predict the likelihood of such compliance nor the d'uect or indirect cosu to the Company of non-co�liance by those third parties or of securing such services from altemate co�liant third pames. In areas in which the Company is uncertain about the anricipated Year 2000 readiness of a significant third parry, the Company is investigating available alternarives, if any. The Company, as a whole, currently estimates that the aggregate cost of its Year 2000 remediation program, which started in 1996, will be approxunately $125 to $175 million, of which an estimated 80% to 90% has been incurred through September 30, 1999. These costs include estimates of the costs of assessment, replacement, repair and upgrade, both planned and unplanned, of certain IT and non-IT systems and their implementarion and tesring. The Co�any anticipates that its remediation progrdm, and related expenditures, may continue into 2001 as temporary solutions to Yeaz 2000 problems are replaced with upgraded equipment. These expenditures have been and are expected to continue to be fimded from the Compan}�s operatiag cash flow and have not and aze not expected to impact materially the Compan�s financial statements. Management believes that it has established an effective program to resolve all significant Year 2000 issues in its control in a timely manner. As noted above, however, the Company has not yet completed all phases of its program and is dependent on third parties whose progress is not within its con�ol. In the event that the Company experiences unanticipated failures of the systems within its control, management believes that the Co�any could experience significant difficulry in produciag and delivering its products and services and conducting its business in the Yeaz 2000 as it has in the past. More importandy, disruptions experienced by third parties with which the Company does business as well as by the economy generally could materially adversely affect the Company. The amount of potential liability and lost revenue cannot be reasonably estimated at this time. As stated above, the Company is now focusing its attention on its contingency and �ansition plans. It has examined its existing divisional standazd business interruption strategies to evaluate whether they would sarisfactorily meet the demands of failures arising from Year 2000-related problems. It is also developing and refining specific �ansition schedules and contingency plans in the event it does not successfully co�lete its remaining remediarion as anticipated or experiences unforeseen problems outside the scope of these standard s�ategies. These plans are intended to provide guidance and alternarives for unanticipated failures of internal systems as well as external failures that may impede any of the Company's businesses from operating normally. The Company intends to examine its status periodically to determine the necessity of implementing such contingency plans or additional s�ategies, which could involve, among other things, manual workarounds, adjusting staffing s�ategies and sharing resources across divisions. Caution Concerning Forward-Looking Statements The Securities and Exchange Commission encourages companies to disclose forward-looldag information so that investors can better understand a company's future prospects and make informed investment decisions. This document, together with management's public commentary related thereto, contaias such "forward-looldng statements" within the meaning of the Private Securiries Litigation Reform Act of 1995, pazticularly statements anticipating future growth in revenues, EBITA and cash flow. Words such as "anticipate", "esrimate", "expects", "projects", "intends", "plans", `believes" and words and terms of similaz substance used in connection with any discussion of future operating or financial performance identify such forward-looking statemeats. Those forwazd-looldag statements aze management's present expectations of future events. As with any projecrion or forecast, they aze inherently susceprible to uncertainty 14 TIME WARNER INC. MANAGEMENT'S DISCUSSION AND ANALYSIS OF RESiJLTS OF OPERATIONS AND FINANCIAL CONDITION—(Continued) and changes in circumstances, and the Company is under no obligation to (and expressly disclauns any such obligation to) update or alter its forward-lookiag statements whether as a result of such changes, new informatioq future events or otherwise. Time Warner operates in highly competirive, consumer driven and rapidly changing media and entertainment businesses that are dependent on government regulation and economic, polirical and social condirions in the counti-ies in which they operate, consumer demand for theu products and services, technological developments and (particularly in view of technological ci�anges) protection of their intellecuial property righu. Time Wamer's actual results could differ materially from management's expectations because of changes ia such factors. Some of the other factors that also could cause actval results to differ from those contained in the forward-looking statements include those idenrified in Time Warner's other filings and: For Time Warner's cable business, more aggressive than expected competition from new technologies and other types of video prograimning dis�ibutors, including DBS; increases in govemment regulation of cable or equipment rates or other temu of service (such as "digital must-cazry" or `tinbundling" requiremeats); increased di�culty in obtaining franchise renewals; the failure of new equipment (such as digital set-top boxes) or services (such as lugh- speed on-line services or telephony over cable or video on demand) to function properly, to appeal to enough consumers or to be available at reasonable prices and W be delivered in a timely fashion; and greater than expected increases in programming or other costs. • For Time Warner's cable programming and television businesses, greater than expected prograz�ing or production costs; public and cable operator resistance to price increases (and the negative impact on premium programmers of increases in basic cable rates); increased regulation of distribution agreements; the sensiriviry of advertising to economic cyclicality; and greater than expected frag�nentation of consu�r viewership due to an increased number of programming services or the iacreased populariry of altematives to television. • For Time Warner's film and television businesses, their ability to continue to attract and select desirable talent and scripu at manageable cosu; increases in production costc generally; fragmentation of consumer leisure and entertainment time (and its possible negative effectc on the broadcast and cable networks, which aze sigaificant customers of these businesses); continued popularity of inercbandising; aad the uncertain impact of technological developmenu such as DVD and the Internet • For Tune Wamer's music business, its abiliry w wntinue to amact and select desirable talent at manageable costs; the timely completion of albums by major aztists; the popular demand for particular artists and albums; its abiliry to continue to enforce and capitalize on its intellectual property righu in digital environments; and the overall strength of global music sales. • For Time Warner's print media and publishing businesses, increases in paper and disazbution costs; the in�oduction and increased populariry of alternative technologies for the provision of news and information, such as the Internet; aad fluctuations in advertiser and consumer spending. • For Time Warner's digital media businesses, their ability to develop products and services that are amactive, accessible and coa�mercially viable in tera�s of content, technology and cost, their ability to manage costs and generate revenues, aggressive competition from existing and developing technologies and products, the resolution of issues conceming commercial activities via the Iaternet, including security, reliability, cost, ease of use and access, and the possibility of iacreased goverament regulation of new media services. • The abiliry of the Company and iu key service providers, vendors, suppliers, customers and govemmental enrities w replace, modify or upgrade computer sysrems in ways that adequately address the Year 2000 issue, including their 15 TIME WARNER INC. MANAGEMENT'S DISCUSSION AND ANALYSIS OF RESiTLTS OF OPERATIONS AND FINANCIAL CONDITION—(Continued) ability to identify and coaect all relevant computer codes and embedded chips, unanticipated difficulties or delays in the implementation of the Corr�any's remediation plans and the ability of third parties to address adequately their own Yeaz 2000 issues. In addition, Time Warner's overall financial s�ategy, including growth in operarions, maintaining its financial ratios and s�engthened balance sheet, could be adversely affected by increased interest rates, failure to meet earniags expectations, significant acquisirions or other transacrions, consequences of the euro conversion and changes in Time Warner's plans, strategies and intentions. ' 16 TIME WARNER INC. CONSOLIDATED BALANCE SHEET (Unaudited) September 30, December 31. 1999 1998 1998 Historical�'� Pro Forma�'� Historical�" (miilions, except per share amouots) ASSETS Current assets Cash and equivalenu ............................................................................................. $ 645 $ 529 $ 442 Receivables, less allowances of $1.385, $1.514 and $1.007 billion ...................... 4,190 4,640 2,885 Inventories ............................................................................................................. 2,195 2,258 946 Prepaid expenses ................................................................................................... 1.570 1342 1.176 Total current assets ................................................................................................ 8,600 8,769 5,449 Noncurrentinventories .......................................................................................... Investment in and amounts due to and from Entertainment Group ........................ Other investinents .................................................................................................. Property, plant and equipment ............................................................................... Music catalogues, contracts and coPYnP,hu ........................................................... Cable television and sports franchises ................................................................... Goodwill................................................................................................................ Otherassets ............................................................................................................ Total assets ............................................ 3,942 1,702 8,489 802 7,863 15,377 1,657 4,219 1,665 8,037 876 6,943 15,830 1.612 1,900 4,980 794 1,991 876 2,868 11,919 863 ..................................................... $4$ Z � $316�! LIABII.ITIES AND SiiAREHOLDERS' EQUITY Current liabilities Accounu payable ................................................................................................... $ 1,456 $ 1,966 $ 996 Pardcipations, royalties and programming costs payable ...................................... 2,865 2,714 1,199 Debt due within one yeaz ....................................................................................... 26 25 19 Other current liabiliries .......................................................................................... 4.229 4.365 2.404 Total current liabilities ........................................................................................... Long-term debt ..................................................................................................... Borrowings against future stock oprion proceeds .................................................. Defeaed income taxes ........................................................................................... Unearned portion of paid subscriptions..•• ............................................................. Otherliabilities .......................................................,.................................._........... Minorityiaterests ................................................................................................... Mandatorily redeemable prefeaed securities of subsidiaries holding solely notes and debentures of subsidiaries of the Company ............................. Shareholders' equity Preferred stock, $.10 paz value, 8.4, 22.6 and 22.6 million shares outstanding, $.840, $2.260 and $2.260 billion liquidation preference ................................... Series LMCN-V common stock, $.O1 par value, 114.1 million shares outstanding. ...................................................................................................... Common stock, $.O 1 paz value, 1.172, 1.118 and 1.118 billion si�ares outstanding. ...................................................................................................... Paid-in capital ...............................................••-•..................................................... Accumulateddeficit ............................................................................................... 8,576 9,070 17,812 17,503 1,230 895 3,848 3,491 742 741 3,688 3,580 3,175 3,027 575 792 1 2 4,618 10,925 895 3,491 741 1,543 575 12 11 11 12,880 13,134 13,134 4 108 4 296 (4.296) Total shareholders' equity ...................................................................................... 8.786 8.852 8.852 Total liabilities and shareholders' equiry .......................................................••....... �4g'432 �47.951 $,31.�Q (a) Thc 1999 financial staurtmu reflat the consolidarion of the Fntertainmrnt Crroup, which substantially consisu of i'WE, reaoaceve w the begirming of 1999. Tirrx Wamer's historical financial statemcntc for 1998 have not been chaz�ged; however, in ader to enhance comparabiliry, pro fonm financial statemenrs for 1998 roticcting the cmuolidarion of the En�mrnt Cmoup are presented supplemrntally (Nou 1). See accom�anying notes. 17 TIME WARNER INC. CONSOLIDATED STATEMENT OF OPERATIONS (iJnaudited) Three Months Ended Nine Months Eoded Seotember 30. Seotember 30. 1999 1998 1998 1999 1998 1998 Historical�'� Pro Forma�'� Historical�'� Hisrorinl�'� Pro Forma�'� Hisrorical�'� (milliom, e:cept per �hare amounts) Revenues (b) ............................................................. $6.723 $6.593 $3.578 $19.345 $18.977 $10.387 Cost � �venues (b)(c) ..:.......................................... (4,007) (4,064) (2,052) (11,404) (11,710) (6,016) Sellin , eneral aad adminis�arive (b)(c) ................. (1,906) (1,788) (1,211) (5,473) (5,264) (3,502) Gain on sale or exchange of cable systems and investrnents (b) ..................................... ............... 477 6 1,248 90 Gain on early temunarion of video distriburion agreement............................................................. - - - 215 Business segment operating income ......................... 1,287 747 315 3,931 2,093 869 Equity in pretax income of Entertainment GrouP�) ..............................................:.............. - - 164 - - 437 Interest and other, net (b)(d) ..................................... (490) (508) (311) (1,387) (1,410) (877) Minority interest ....:.................................................. � ) � ) (358) (200) - 59 53 - Corporate expenses (b) ............................................. 40) �38) 20) 120) 112 Income before income taxes ..........:.......................... 698 Iacome tax provision ................................................ 317) Income before ex�aordinary item ............................ 381 Extraordinary loss on retirement of debt, net of $9 million income tax benefit in 1999 ................. (121 Netincome ...............................................:............... 369 Preferred dividend requirements .............................. _�) Net income (loss) applicable to common shares....... � Income (loss) per common share before ex�aordinary item: 148 109) 39 39 �) $--�-Z� 148 109) 39 39 �) �.) �_) _L) 2,066 371 371 954 293 293) 1,112 78 7g 12) _ _ 1,100 78 7g 45) 236) 236) � � �) Basic...........................:........................................ $--� � �--�.Q � � $.�Q—) Diluted ................................................................. �-�-� �� $(0.13, Net income (loss) per common share: Basic.................................................................... �$ 4 $!0•131 Diluted ................................................................. $�2.Z � QQ� ��1 �$ �) $(0•13) Average common shares: Basic.................................................................... 1 � � ¢ -�4- �4 .1$4 -4 1�$4,_Q Diluted................................................................. � � � � � -�$-�- (a) The 1999 financial stauments reflect the consolidation of the Entertainment Group, which substantially consisu of iWE, retroacdve to the begirming of 1999. Time Wamer's historical financial statements for 1998 have not ban changed; however, in order to rnhance comparability, pro fortna financial staumrnts for 1998 rcflecdng the consolidaoon of the Enurtainment Group are presrnted supplemrntally (Note 1). (b) Indudes the following income (expenses) resulting trom transactions with rolated companies and, for 1998 historical purposes only, the Entertainment Group: Revenuu ......................................................................... $109 SI18 $120 $376 5357 $334 Castof revenues .............................................................. Sellin (50) (�) i70) (151) (87) (207) B. Brneral and administraeve .................................. (6) (7) (8) (17) (18) (28) Gain on sale or enchange of cable systems and investrrKnts 427 _ _ qZ� _ Equiry in pretax income of Entertainmrnt Group ............. - - 72 - - 52 Interest and otha, net ...................................................... 2 2 (2) 10 1 (g) Curpor'ste exPenses .......................................................... - - 18 Sq (c) Includes depreciation and amortirrdon expense of : ............. 5641 5658 $295 51,853 $1,984 $8g4 (d) Includes an approximate 5115 million pretax gam tecog�ized in ihe ucond quarter of 1999 in camection with the iniaal public offering of a 20% inurest in Time Wamer Telecom Inc. See accompanying notes. 1 g TIME WARNER INC. CONSOLIDATED STATEMENT OF CASH FLOWS (IJnaudited) OPERATIONS Netincome ............................................................................................................ Adjustinents for noncash and nonoperating items: Extraordinary loss on retirement of debt ............................................................... Depreciation and amortization ............................................................................... Noacash interest expense ....................................................................................... Excess of dis�ibutions over equity in pretax income of EntertainmentGroup ......................................................................................... Changes in operating assets and liabilities ............................................................. Cashprovided by operarions ................................................................................. Nine Months Ended Seotember 30. 1999 1998 1998 Historical'•' Pro Forma�'� Historical�'� (millioas) $1,100 $ 78 12 - 1,853 1,984 3 29 (166) 247) 2.802 1.844 INVESTING ACTIVIT'IES Consolidation of the Entertainment Group's cash and equivalenu ........................ 87 - Iaves�ents and acquisitions ................................................................................. (423) (421) Capital expenditures .............................................................................................. (1,532) (1,440) Investinentproceeds .............................................................................................. 476 939 Proceeds received from dis�ibution of TWE Senior Capital ................................ - - Cash provided (used) by investing activities ........................................................ FINANCING ACTIVITIES Boaowings....................................................... ..................................................... Debtrepayments .................................................................................................... Borrowings against future stock option proceeds .................................................. Repayments of boaowings against future stock option proceeds .......................... Redemption of mandatorily redeemable prefeired securiries of subsidiary........... Repurchases of Time Warner coa�non stock ......................................................... Dividendspaid ....................................................................................................... Proceeds received from stock option and dividend reinves�nent plans ................. Other...................................................................................................................... Cash used by financing activities ........................................................................... INCREASE (DECREASE) IN CASH AND EQiJIVALENTS ......................... -� CASH AND EQiJIVALENTS AT BEGINNING OF PERIOD ......................... 1392) 922) 3,127 3,184 (2,811) (3,140) 335 I,O15 - (533) (217) - (1,636) (1,944) (226) (394) 350 599 (129) (I5g) 1 207 203 442 CASH AND EQUIVAI.ENTS AT END OF PERIOD ....................................... � 1 371) (449) 967 $ $ 78 884 29 168 35 1.194 (86) (348) 458 455 479 1,669 (2,300) 1,015 (533) (1,944) (394) 599 (37) (1.925) (252) 645 � (a) The 1999 finaneial statemmt� reflect the cansdidatip� of the Fnterraimnent C�roup, which substaruially ca�sists of TWE, rcffoacdve to the beginning of 1999. Time Wama's hisrorical fa�ancial statemrnts for 1998 have not bern cManged; however, in order to rnhance comparabiliry, pro forma financial statrmenu for 1998 rcflecong the consolidadon of the Fntertainmrnt Group ars presrntcd supplertxntally (Note I). See accompaaying notes. 19 TIME WARNER INC. CONSOLIDATED STATEMENT OF SHAREHOLDERS' EQUITY (Unaudited) Nine Months Ended Seotember 30. 1999 1998 Historical Historical (millions) BALANCE AT BEGII�TI�IING OF PERIOD ............................................................................ $8,852 Netincome ................................................................................................................................. 1,100 Other comprehensive income (loss) ........................................................................................... (40) Cumulative effect of change in accounting for derivative instrumenu, net of $3 million tax benefit ............................................................................................................. - Comprehensive income (loss)�'� .................................................................................................. 1,060 Commonstock dividends ........................................................................................................... Preferredstock dividends ........................................................................................................... Repurchases of Tnne Warner common stock .............................................................................. Issuance of common stock in connecrion with the conversion of the zeracoupon convertible notes due 2013 ............................................................................... Other, principally shares issued pursuant to stock option, dividend reinvestinentand benefit plans ............................................................................................... $9,356 78 (59) � (170) (161) (45) (236) (1,636) (1,944) 1,150 725 974 BALANCEAT END OF PERIOD .......................................................................................... � �4Q (a) Comprehensive incmne poss) for the three months rnded September 30, 1999 and 1998 was $339 million and $(16) million, respectively. Comprehensive loss for the three-month period ended September 30, 1998 includes an S18 million cumuladve effect of a change in accounting for derivadve inswments that occurrcd during the period. See accompanying notes. 20 TIME WARNER INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Unaudited) 1. DESCRIPTION OF BUSINESS AND BASIS OF PRESENTATION Description of Business Time Wamer Inc. ("Time Wamer" or the "Company") is the world's largest media and entertainment company. Time Warner's principal business objective is to create and distribute branded inforcnation and entertainmeat copyrighu throughout the world. Tune Warner classifies its business interesu into five fundamental areas: Cable Networks, consisting principally of interests in cable television programming; Publishing, consisring principally of interests in magazine publishing, book publishing and direct mazketing; Music, consisting principally of iaterests in recorded music and music publishing; Filmed Entertainment, consisting principally of interests in filmed entertainment, television production and television broadcasting; and Cable, consisting principally of interests in cable television systems. Each of the business interests within Cable Networks, Publishing, Music, Filmed Entertainment and Cable is important to managemeat's objective of iacreasing shareholder value through the creation, exunsion and distribution of recognizable brands and capyrights throughout the world. Such brands and capytights include (1) leading cable television networks, such as HBO, Cinemax, CNN, TNT and TBS Superstatioq (2) magazine franchises such as T:me, People and Sports Illustrated and direct marketing brands such as Time Life Inc. and Book-of-the-Moath Club, (3) copyrighted music from many of the world's leading recording artisu that is produced and distributed by a family of established record labels such as Warner Bms. Records, Atlaatic Records, Elek�a Entertainment and Warner Music International, (4) the unique and extensive film, television and animation libraries of Warner Bros. and Turaer Broadcasting System, Inc. ("TBS"), and �ademarks such as the Looney Tunes characters, Batman and The Flintstones, (5) The WB Network, a national broadcasting network launched in 1995 as an extension of the Warner Bros. brand and as an addirional distnbution oudet for the Compan�s collection of children's cartoons and television progra�ring, and (6) Ti� Wazner Cable, currendy the largest operator of cable television systems in the U.S. Financial information for Tune Warner's vazious business segrnents are presented herein as an indication of fmancial performance (Note 8). Except for start-up losses inc�ured in co�ection with The WB Network, Time Warner's principal business se�ents generate significant operating income and cash Aow from operations. The cash flow from operations generated by such business segments is considerably greater than their operating income due to sigaificant amounts of noncash amorbzation of intangible assets recogniud ia vazious acquisitions accounted for by the purchase method of accountiag. Noncash amoatizatiam of intangible assets zecorded by Time Warnds business segments ar�unud to $321 million and $335 millio�n for the three months ended Sepumber 30, 1999 and 1998, respectively, and $948 million and $1.001 billion m the nine months eaded September 30, 1999 and 1998, respectively. Basis of Presentation Consolidation of TWE A majority of Time Wazner's interests in filmed entertainment, television production, television bmadcasting and cable television systems, a� a portion of its mterests in cable television programming are held thmugh Time Wa�er Entertaina�ent ComPanY� L.P. ("T'WE"). Tnne War�r owns general and limited par�eiship interests in TWE consisting of 74.49% of the pro rata prioriry capital ("Series A Capital") and residual e.quity capital ("Residual Capiral"), and l00% of the junior priority capital ("Series B Capital"). The remaining 25.51% limited parmership interests in the Series A Capiral and Residual Capital of TWE aze held by a subsidiary of MediaOne Group, Inc. ("MediaOne"). Since 1993, Time Warner historically had not consolidated TWE and certain related companies (the "Entertainment Group") for fmancial reportiag purposes because MediaOae had rights that allowed it to pardcipate in the management of TWE's businesses. However, in August 1999, TWE received a notice from MediaOne concerning 21 TIME WARNER INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued) (iJnaudited) the terminarion of its covenant not to compete with TWE. The temunation of that covenant is necessary for MediaOne to complete its proposed merger with AT&T Coip. ("AT&T"). As a result of the termination notice and the operarion of the TWE partnership agreement, MediaOne's rights to participate in the management of TWE's businesses ternunated immediately and irrevocably. MediaOne retains only certain protecrive governance righu pertaiuing to certain litnited matters affecting TWE as a whole. Because of this significant reducrion in MediaOne's rights, Time Warner's 1999 financial statements reflect the consolidation of the Entertainment Group, which substanrially consists of TWE, reu�oacrive to the beginning of 1999. Time Warner's historical financial statements for 1998 have not been changed, but aze no longer comparable to 1999 because the Entertainment Group was reflected on an unconsolidated basis using the equity method of accounting. Accordingly, in order to enhance comparabiliry, pro forma financial statemenu for 1998 reflecting the consolidarion of the Entertairunent Group are presented supplementally. 1998 Stock Split Per common share and average common share amounts for all prior periods have been restated to give effect to a two-for-one common stock split that occurred on December 15, 1998. Reclassifications Certain reclassifications have been made to the prior year's financial statements to conform to the 1999 presentarion. Interim Financial Statemenu The accompaaying consolidated financial statements are unaudited but, in the opinion of managemeat, contain all the adjustinents (consisting of those of a aormal recutring nature) considered necessary to present fairly the financial posirion and the results of operations and cash flows for the periods presented in conformity with generally accepted accounting principles applicable to interim periods. The accompanying consolidated financial sratements should be read in conjunction with the audited consolidated financial statements of Time Wamer included in its Affival Report on Form 10-K for the yeaz ended December 31, 1998, as amended (the "1998 Form 10.K"). 2. CABLE TRANSACTIONS Time Warner's operating results have been affected by a number of significant cable-related �ansacrions that occurred in each period. Gain on Sale or Ezchange of Cable Television Systems aad Investments In 1999 and 1998, largely in an effort w enhaace their geograplric clustering of cable television properties, Time Warner, largely through TWE, sold or exchanged various cable television systems and investments. The 1999 �ansactions included a large exchange of cable television systems serviag approximately 575,000 subscribers for other cable television systems of compazable size owned by TCI Communications, Inc., a subsidiary of AT&T Corp., and a large exchange of cable television systems serving approximately 310,000 subscnbers for other cable television systems of comparable size owned by MediaOne. As a result of these transactions, the operating results of Time Warner include net pretax gains for the third quarter of $477 million in 1999 and $6 million in 1998 on a pro forma basis. Net pretax gains for the first nine months of the year amounted to $1.248 billion in 1999 and $90 million in 1998 on a pro forma basis. There were no gains included in the operating results of Tune Warner oa a historical basis for 1998. 22 T'I1VIE WARNER INC. NOTES TO CONSOLIDATED FII�ANCIAL STATEMENTS--(Continued) (Unaudited) Gain on Time Warner Telecom's Initial Public Offering In May 1999, Time Warner Telecom, a comperirive local exchange carrier that provides telephony services to businesses, cornpleted an initial public offering of 20% of its common stock (the "Time Warner Telecom IPO"). Time Warner Telecom raised net proceeds of approxunately $270 million. Approximately $180 million of these proceeds were used to pay obligations owed to Time Waraer and TWE. In tum, Tuae Warner and TWE used those proceeds principally to reduce bank debt. In connection with the Time Warner Telecom IPO and certain related transacrions, Time Warner's ownezship interest in Time Warner Telecom was diluted from 61.98% to 48.21 %. As a result, Time Warnei recogaized a pretax gain of approximately $115 million ($.OS per basic common share after taxes). This gain has been included in interest and other, net, in Time Warner's 1999 consolidated statement of operarions. Primestar Time Waraer and TWE own an approximate 24% equiry interest in Primestar. In January 1999, Primestar, an indirect wholly owned subsidiary of Pria�estar and the stockholders of Primestar entered into an agreement to sell Primestar's medium-power direct broadcast satellite business and assets to DirecTV, a competitor of Primestar owned by Hughes Elecoronics Corp. In addition, a second agreement was entemd into with DirecTV, pursuant to which DirecT'V agreed to purchase Primesffir's rights with respect to the use or acquisition of certain high-power satellites from a wholly owned subsidiary of one of the stockholders of Primestar. In April 1999, Primestar closed on the sale of its medium power direct broadcast satellite business to DirecTV. Then, in Juae 1999, Primestaz completed the sale of its high power satellite rights to DirecTV. As a result of those �ansactions, Primestar began to substantially wind down its operations during the first quarter of 1999. Tia�e Waraer recognized its share of Priinestar's 19991osses under the equiry method of accounting. Such losses are included in interest and other, net As of September 30, 1999, Primestar has substantially completed the wind down of its operations. As such, future wind-down losses are not expected to be material to Time Waraer's operating results. 3. GAIN ON TERMINATION OF MGM VIDEO DISTRIBUTION AGREEMENT In March 1999, Warner Bros. and Me�o-Goldwyn-Mayer, Inc. ("MGM") terminated a long-term distnburion agreemeat under which Warner Bros. bad exclusive worldwide distdbution rights for MGM/United Artists home video product In coffiection with the early te�nation and settlemeot of dris disonbution agreement, Warner Bros. recognized a net pretax gam of approximately 5215 million ($.10 per basic co�mon share), which bas been included in operating iacome in the accompanying consolidatod statement of operations. 23 TIME WARNER INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued) (Unaudited) 4. INVENTORIES Inventories consist of: F111T1 COSiS: Released, less amortizarion ................... Completed and not released .................. In process and other .............................. Library, less amortization ..................... Programming costs, less amortization ....... Magazines, books, recorded music and merchandise.......................................... Sentember 30. 1999 Historical Current Noneurrent $ 682 $ 932 194 64 36 746 - 1,486 742 714 541 Total......................................................... � � 5. INVESTMENT IN ENTERTAINMENT GROUP December 31. ] 998 December 31, 1995 Pro Forma Historical Current �o�current Current Noncurrent (millions) $ 665 $1,051 $ 51 199 76 20 24 912 2 - 1,567 - 883 613 457 487 416 � �-�21. �.24� - $ 308 240 1,007 345 �-�20- Time Waraer's inves�nent in the Entertainment Group consists substantially of iu inveshnent in TWE. TWE is a Delaware limited parmership that was capitalized in 1992 to own and operate substantially all of the Filmed Entertainment-Warner Bros., Cable Networks-HBO and Cable businesses previously owned by subsidiaries of Time Warner. Time Waraer, through its wholly owned subsidiaries, collectively owns general and limited parmership interests in TWE consisting of 74.49% of the Series A Capital and Residual Capital, and 100% of the Series B Capital. The remaining 25.51 % limited parmership interests in the Series A Capital and Residual Capital of TWE aze held by MediaOne. Certain Time Warner subsidiaries aze the general paroners of TWE (the "Time Warner General Par�ers"). The TWE parniership agreement provides for special allocarions of income, loss and dish�butions of parmeislup capital, including priority distributions in the event of liquidation. TWE reported net income of $1.640 billion and $435 million for the nine months ended September 30, 1999 and 1998, respectively. Because of the prioriry rights over allocarions of income and disuibutions of TWE held by the Time Warner General Parmers, all of TWE's income was allocated to Time Warner and none was allocated to MediaOne. In addition, the asseu and cash flows of TWE aze restiicted by the TWE parmership and credit agreements. As such, they are unavailable for use by the parmers except through the payment of certain fees, reimbursemenu, cash dis�ibutions and loans, which aze subject to limitations. TWE had $63 billion of net assets at September 30, 1999. Pursuant to the TWE parmership agreement, TWE makes certain cash distributions to its par�ers. During the nine months ended September 30, 1999, the Time Warner General Par�ers received distributions from TWE in the amount of $1.116 billion, consisting of $627 million of senior capital dis�ibutions (representiag the return of $454 million of con�ibuted capital and the dis�bution of $173 million of priority capital retwn), $316 million of tax-related distributions and $173 million of stock option related distnbutions. During the nine months ended September 30, 1998, the Time Waraer General Pazmers received dis�iburions from TWE in the amount of $1.060 billion, consisting of $579 million of senior capital dis�ibutions (representing the retum of $455 million of contributed capital and the distribution of $124 million of priority capital return), $264 million of tax-related dis�ibutions and $217 million of stock option related distributions. 24 TIME WARNER INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—{Continued) (Unaudited) 6. MANDATORILY REDEEMABLE PREFERRED SECURI3'IES REIT Preferred Stock In February 1997, a newly formed, substantiaily owned subsidiary of TWE (the "REIT') issued 250,000 shares of preferred stock ("REIT Preferred Stock"). The REIT was intended to qualify as a real estate investment trust under the Internal Revenue Code of 1986, as amended. In March 1999, the RETT redeemed all of iu shares of REIT Preferred Stock at an aggregate cost of $217 million, which approxiinated net book value. The redemprion was funded with borrowings under TWE's bank credit agreement. Pursuant to its terms, the REIT Preferred Stock was redeemed as a result of proposed changes to federal tax regulations that substantially increased d�e likelihood that dividends paid by the RETT or interest paid to the RETT under a mortgage note of TWE would not be fully deductible for federal income tax purposes. Preferred Trust Securities In December 1995, Time Warner Companies, Inc. ("TW Companies"), a wholly owned subsidiary of Time Warner, issued approximately 23 million Company-obligated mandatorily redeemable preferred securities of a wholly owaed subsidiary ("Prefeaed Trust Securities") for aggregate gross proceeds of $575 million. The sole assets of the subsidiary that is the obligor on the Preferred Trust Securities are $592 million priacipal amount of 8'/a% subordinated debentures of TW Companies due December 31, 2025. Cum�lative cash distributions are payable on the Preferred Trust Securiries at an annual rate of 8'/e%. The Preferred Trust Securities are mandatorily redeemable for cash on December 31, 2025, and T'W Companies has the right to redeem the Preferred Trust Securities, in whole or in part, on or after December 31, 2000, or in other certain circu�tances. If TW Companies elects to redeem these securities, the redemption amount would be in each case at an amount per Prefeaed Trust Security equal to $25 per securiry, plus accrued and unpaid distributions thereon. Time Warner has certain obligations relating to the Preferred Trust Securities which amount to a full and uaconditional guaranty (on a subordinated basis) of its subsidiary's obligations with respect thereto. 7. SHAREHOLDERS' EQLTITY Preferred Stock Conversion In July 1999, Time Warner issued appmximately 46 million shares of common stock in connection with the conversion of all outstanding 11 million shares of its Series D convertible preferred stocic. Because holders of Series D prefeaed stock were entitled to cash dividends at a preferential rate through July 1999, Time Warner's historical cash dividend requiremenu will be reduced, going forward, by approximately $30 million on an annualized basis. Series LMCN-V Stock Split In May 1999, Tiaye Wamer amended the tera�s of its Series LMCN-V coa�on stcek, which effectively resulted in a twwfor-one stock split and the issuance of approximately 57 million shares of Series LMCN-V coa�mon stock As a resul� each share of Series LMCN-V commoa stock now is equivalent effectively to one sbare of common stock instead of two. Because the equivalent number of shares of coammon stock did not change, the split did not have any effect on Time Waraer's consolidated financial statements. Shares of Series LMCN-V common stock coatinue to have limited voting rights. 25 TIME WARNER INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--{Continued) (Unaudited) Common Stock Repurchase Program In January 1999, Time Wamer's Board of Directors authorized a new common stock repurchase program that allows the Company to repurchase, from time to time, up to $5 billion of common stock. This program is expected to be completed over a three-year period; however, actual repurchases in any period will be subject to market condirions. Along with stock opuon exercise proceeds and borrowings under Tune Wamer's $13 billion stock oprion proceeds credit facility, additional funding for this program is expected to be provided by anticipated future free cash flow and financial capaciry. During the first nine months of 1999, Time Warner acquued 243 million shares of its common stock at an aggregate cost of $1.636 billion. These repurchases increased the cumulative shares purchased under this and its previous common stock repurchase program begun in 1996 to approximately 119.4 million shares at an aggregate cost of $4.676 billion. Income (Loss) Per Common Share Before Eatraordinary Item Set forth below is a reconciliation of basic and diluted income (loss) per common share before extraordinary item for each period. Income (loss) before extraordinary item- basic ...................................................... Interest savings, net of tax�2� ......:........................ Preferred dividends ............................................. Income (loss) before ex�aordinary item- diluted ..............................:.................... Average number of common shares outstanding - basic .......................................... Dilutive effect of stock options ........................... Diludve effect of convertible prefeaed shares ... Average number of common shares outstanding - diluted ....................................... Td� MO°� Nlae Moothe Ended a_Atember ]0. Eeded ¢_'temEer 3�J. 1999 1998 1998 1999 1998 HLttorlal Ctv F°rma�� Hlstorical�n Hift°riea� Pro form��,� H�on �� (mlWom. oapt per �hne �monob) $ 372 $ (37) $ (37) $1,067 $ (158) $ (158) 12 - - 31 - - 9 - - 45 � � �� ) �) 1,288.9 1,202.6 1,202.6 1,260.5 1,184.0 1,184.0 71.8 - - 733 - - 37.1 - 66.6 � � � � � � Income (loss) per common share before extraordinary item Basic ........................................:................... $�Q �) $ (�0.03,1 $ 0.85 $� �-�- Diluted ......................................................... �9�2$ �4 ) (0.03) �Q.$� �1. �) (1) 1998 basic and dilueed 'mcome (loss) pa wemion share beforc extraordinary item are the same because the etiect of Time Wamer's stock opaons and convertible prcferted stack waz antidilueve. (2) Reflxts the required use of a portion of the proaeds 5vm thc fuuae exer�ise of employee stock opdons co rcpay all outstanding bornowings �mder Time Warner's stock opdon proceeds crcdit faciliry. 8. SEGMENT INFORMATION Time Wazner classifies its busiaess interests into five fundamental azeas: Cable Networks, consisting priacipally of interests in cable television programming; Publishing, consisting principally of interests in magazine publishing, book publishing and direct mazketing; Music, consisting principally of interests in recorded music and music publishing; Filmed Entertainment, consisting principally of interests in filmed entertaintnent, television production and television broadcasting; and Cable, consisring principally of interests in cable television systems. 26 TIME WARNER INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued) (Unaudited) Information as to the operations of Time Warner in different business segments is set forth below based on the nature of the products and services offered. Time Wamer evaluates performance based on several factors, of which the primary fu�ancial measure is business segment operating income before noncash amortization of intangible assets ("EBITA"). As a result of the consolidation of the Entertainment Group in 1999, Time Warner's and the Entertainment Group's business segments have been combined. Accordingly, segment information for 1998 has been restated in order to conform to the new presentation. The operating results of Time Warner's Cable segment reflect (i) the transfer of Time Wamer Cab]e's direct broadcast satellite openrions to Primestar, a separate holding company, effective as of April 1, 1998, (ii) the formarion of the Road Runner joint venture to operate and expand Time Warner Cable's and MediaOne's existing high-speed online businesses, effective as of June 30, 1998, (ai) the reorganization of Time Warner Cable's business telephony operarions into a separate entity now named Time Wamer Telecom Inc., effecrive as of July 1, 1998 and (iv) the formarion of a joint venture in Texas that owns cable television systems serving approxunately 1.1 million subscribers, effecrive as of December 31, 1998. These transactions are all more fully described in Time Warner's 1998 Form 10-K. Revenues CableNetworks ........................................................................................ Publishing................................................................................................. Music........................................................................................................ Filmed Entertainment ............................................................................... Broadcasting-The WB Network ........................... .................................... Cable........................................................................................................ Intersegment elimination .......................................................................... Three Mont6s Nine Months Ended Seotember 30, Ended Se�tember 30. 1999 1998 1999 1998 (millions) $1,450 1,110 852 2,208 84 1,342 1323) Total business segment revenues .............................................................. 6,723 Entertainment Group revenues reported on an unconsolidated basis"' ..... $ 1,330 $ 4,425 $ 3,985 1,076 3,237 3,160 938 2,616 2,731 2,272 5,688 5,790 64 246 170 1,288 3,968 4,015 �375) (835) 874) 6,593 19,345 18,977 3�) - ig�) Total consolidated revenues ...................................................................... $§� $ 3"57g � $10.3g7 (1) Represents amounu prcwiauly reported fa the Entertaimntnt Crroup, adjusted by inurcortq�any eliminadons and otha cmuolidating adjustmrnts necessary for Time Warner w rcflect the Entertainmmt Group on a consolidated basis. 27 TIME WARNER INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--{Continued) (Unaudited) EBITA�� CableNetworks ........................................................................................ Publishing.................................................... ............................................. Music........................................................................................................ Filmed EntertainmenM� ............................................................................. Broadcasting-The WB Network ............................................................... Cable�� ...................................................................................................... Intersegment elimination .......................................................................... Total business segment EBITA ................................................................ Three Months Nine Months Ended Seotember 30. Ended Seotember 30. 1999 1998 1999 199g (millions) 6 328 129 76 228 (24) 894 (23l 1,608 $ 271 112 99 233 (17) 417 �) 1,082 � 1,003 419 279 806 (95) 2,477 _L) 4,879 $ 844 373 288 497 ��g) 1,246 _L) 3,094 Entertainment Group EBITA reported on an unconsolidated basis�'� ........ - �566) - 1 626) Total consolidated EBITA ........................................................................ 1•60g $�1Cz 4$J� � (1) EBIT'.4 *epraent� business segment o}xradng income before noncash anarazation of intan�ble assets. After deducring amortization of intangible assets, Time Warner's historical business segmrnt operating income for the third quarta was $1.287 billion in 1999 and 5315 million in 1998. Time Wamer's historical business segmrnt operadng income for the first nine months of the year was $3.931 billion in 1999 and $869 million in 1998. (2) includes a net pretax gain of approximately $215 million recognized in the first quarter of 1999 in connecaon with the eazly tem�ination and settlement of a long-temi home video distribueon agreemrnt. (3) ]ncludes net pretax gains relaeng to the sale or exchange of cerrain cable ulevision systems and invesmients of $477 million in the third quarter of 1999 and $6 million in the third quarter of 1998. Similarly, nine month results include net pretax gains of 51.248 billion in 1999 and $90 million in 1998. (4) Represents amounts previously reporced for the Entertainmmt Crroup, adjusted by intercom�any eliminaaons and other consolidating adjustrnenu necasary for Time Wamer to reflect the Entertainment Group on a consolidated buis. Depreciation of Property, Plant and Equipment CableNetworks ........................................................................................ Publishing................................................................................................. Music........................................................................................................ Filmed Entertainment ............................................................................... Broadcasting-The WB Network ............................................................... Cable........................................................................................................ Total business segment depreciation ........................................................ Entertainment Group depreciation reported on an unconsolidated basis"� ................................................................................................... Total consolidated depreciarion ............................................................... Three Months Nine Months Ended Seotember 30. Ended Sentember 30. 1999 1998 1999 1998 (millions) $ 33 $ 31 19 20 19 16 46 49 - 1 203 206 320 323 L) $ 320 $�4 � 96 $ 88 57 58 S4 54 114 130 1 1 583 652 905 983 = 69S) $24� $ 285 (1) Represrnts amoimu previously reported for the Entertainrrxnt Group, adjusted by intercorr�any eliminauons and other consolidacng adjustrnrnt� necessary for Time Wamer to reflect the Fa�tertainmrnt Group on a consolidaud buis. 28 TIME WARNER INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--{Continued) (Unaudited) Three Months Nine Months Ended Seotember 30. Ended Seotember 30. 1999 1998 1999 1998 (millions) Amortization of Intangible Assets�'� CableNetworks ........................................................................................ $ 51 Publishing................................................................................................. 11 Music........................................................................................................ 65 Filmed Entertainment ............................................................................... 51 Broadcasting-The WB Network ............................................................... 1 Cable........................................................................................................ 142 Total business segment amortizarion ........................................................ 321 Entertainment Group amortization reported on an unconsolidated basis�� ................................................................................................... - $ 50 $152 $ 150 10 31 27 69 202 208 58 151 166 - 3 2 148 409 448 335 948 1,001 f134) = 402 Total consolidated amortization ................................................................ $311 �291 $�3.$ $ 599 (1) Artror�raaovi includa amortiradon relaang to all business comb'viations accamted for by the p�u�chase method, includ'mg the $14 billian acquisiaan of Wamer Communications Inc. in 1989, the $6.2 billion acquisition of Tutner BroadcaSting System, [nc. in 1996 and the 52.3 billion of cable acquisitions in 1996 and 1995. (2) RepRSrncs amount� previously feported for the Fntenainrtxnt Group, adjasud by intercompany eliminadons and oUxr consolidating adjustrnrnt� necessary for Time Wamer to reflect the Entcrtainmrnt Group on a consolidaud basis. 9. COMMITMENTS AND CONTINGENCIES Time Warner is subject to numerous legal proceedings. In management's opinion and considering established reserves, the resolurion of these matters will not have a material effect, individually and in the aggregate, on Time Warner's consolidated financial statements. 10. ADDITIONAL FTNANCIAL INFORMATION Additional financial information with respect to cash flows is as follows: Interest expense ................................................ Cash paymenu made for interest ...................... Cash payments made for income taxes ............. Income tax refunds received ............................. ................................... ................................... ................................... ..........-• ....................... Nine Months Ended Seotember 30. 1999 1998 1998 istorical Pro Forma Historical (millioos) ........ $1,116 $1,082 $669 ........ 1,137 1,122 708 ........ 304 251 191 ........ 43 51 48 Noncash iavesting activiries include the exchange of certain cable television systems in 1999 and 1998 (see Note 2). Noncash investing activities in the first six months of 1998 also iacluded the �ansfer of cable television systems (or interests therein) serving approximately 650,000 subscribers that were formerly owned by subsidiaries of Time Warner to the TVJE-AdvancelNewhouse Par�ership, subject to approximately $1 billion of debt, in exchaage for common and preferred partnerslup interests therein, as well as certain related �ansactions (collectively, the `"TWE-A/N Tiansfers"). For a�re comprehensive description of the TWE-A/N Transfers, see Time Warner's 1998 Form 10-K. 29 TIME WARNER INC. SUPPLEMENTARY INFORMATION CONDENSED CONSOLIDATING FINANCIAL STATEMENTS (unaudited) Time Wamer Companies, Inc. ("TW Companies") and Turner Broadcasting System, Inc. ("TBS" and, together with T'W Companies, the "Guarantor Subsidiaries") are wholly owned subsidiaries of Time Wamer Inc. ("Time Wamer"). Time Warner, TW Companies and TBS have fully and uncondirionally guaranteed all of the outstanding publicly �aded indebtedness of each other. Set forth below are condensed consolidaring fmancial statemenu of Time Wamer, including each of the Guarantor Subsidiaries, presented for the information of each company's public debtholders. Separate financial statements and other disclosures relating to the Guarantor Subsidiaries have not been presented because management has determined that this informarion would not be material to such debtholders. The following condensed consolidating financial statements present the results of operarions, financial posiuon and cash flows of (i) Time Warner, TW Companies and TBS (in each case, reflecting investments in its consolidated subsidiaries under the equity method of accounting), (ii) the direct and indirect non-guarantor subsidianes of Tune Wamer and (iii) the eliminations necessary to arrive at the information for Time Warner on a consolidated basis. These condensed consolidating financial statements should be read in conjuncrion with the accompanying consolidated financial statements of Time Warner. Consolidating Statement of Operations For The Three Months Ended September 30, 1999 Time 'fW Warner om anies Revenues..................................................... � Cost of revenues (1) ...................:.................. - Selling, general and administrative (1) ......... - Gain on sale or exchange of cable systems and investrnents ........................................ - Operating expenses ....................................... - Business segment operating income ............. - Equity in pretax income of consolidated subsidiaries ........................................... 782 .... Interest and other, net ................................... (63) Minority interest ........................................... - Corporate expenses ....................................... 21) Income before income taxes ......................... 698 Income tax provision .................................... 317) Income before ex�aordinary item ................ 381 Extraordinary loss on retirement of debt, net of $9 million income tax benefit......... �) Netincome ................................................... � (1) Includes depreciation and amortiTation expenseof : ........................................................... � 30 � 869 (158) 14 697 305 392 Non- Guaraotor TBS Subsidiaries (millions) $200 6 586 (88) (3,991) (50) (1,856) = 477 138) (5,370) 62 1,216 81 - (39) (203) - (59) �) L?) 100 919 �) 386) 43 533 12) = — $3$Q �--�.,i $ 533 Time Elimioa- Wamer tions Consolidated $ (63) $6.723 72 (4,007) - (1,906) 477 72 (5.436) 9 1,287 (1,732) �2�) 34 (1,716) 748 (968) 12 �� (490) (59) �) 698 317) 381 �) � � �2 S�2 �) S bat TIME WARNER INC. SUPPLEMENTARY INFORMATION CONDENSED CONSOLIDATING FINANCIAL STATEMENTS--{Continued) (unaudited) Consolidating Statement of Operations For The Three Mont6s Ended September 30, 1998 Non- Time TW Guarantor Warner Comoanies TBS Subsidiaries (millions) Revenues ..................................................... � $ - $176 $3.418 Cost of revenues (1) ...................................... - - (83) (1,985) Selling, general and adminis�arive (1) ......... _ _ �45) 1 166) Operatiag expenses ....................................... - _ �8) 3 151) Business segment operating income ............. - - 48 267 Equity in pretax iacome of consolidated subsidiaries ............................................... 203 Equity in pretax income of Entertainment Group...................................................... - Interest and other, net ................................... (35) Corporate expenses ....................................... L) Income before income taxes ......................... 148 Income tax provision .................................... L9) Netincome ................................................... �Q (1) Induda depreciadon and arnortiration expense of : ........................................................... � 31 335 (183) �) 138 L?) � � 87 (37) �) 95 �) $41 F3� 196 (40) 15) 408 232 � �F k3�i Elimina- tions �16) 16 16 (625) (32) (16) 32 (641) 388 �� Time Warner Consolidated 3 578 (2,052) 1 211) (3,263) 315 0 164 (311) � 148 �) � � TIME WARNER INC. SUPPLEMENTARY INFORMATION CONDENSED CONSOLIDATING FINANCIAL STATEMENTS--{Continued) (unaudited) Consolidating Statement of Operations For The Nine Months Ended September 30, 1999 Time TW Warner Como9nies Revenues..................................................... $ - Cost of revenues (1) ...................................... - Selling, general and administrative (1) ......... - Gain on sale or exchange of cable systems and inves�nents ........:............................... - Gain on eazly terminarion of video distriburion agreement .............................. _ Operating expenses ....................................... - Business segment operating income ............. - Equity in pretax income of consolidated subsidiaries ............................................... 2,316 Interest and other, net ................................... (185) Minority interest ........................................... - Corporate expenses ....................................... �?) Iacome before income taxes ......................... 2,066 Income tax provision .................................... (954) Income before extraordinary item ................ 1,112 Extraordinary loss on retirement of debt, netof tax ................................................... �) Net income .......................•••••-•..................... � $ 2,505 (504) 42) 1,959 892) 1,067 �1?) � (1) Includes depreciation and amortization exprnse of :............................................................ �•— � 32 hon- Guarantor TBS Subsidiaries (millions) $ 626 18 766 (288) (11,163) (154) (5,319) - 1,248 - 215 442 15 019) 184 3,747 315 - (108) (528) - (358) 12) (103) 379 2,758 �) 1 231) 177 1,527 $ 177 $� Time Elimina- Warner tions Consolidated $ 47) 19 345 47 (11,404) - (5,473) - 1,248 215 47 15 414) - 3,931 (5,136) (62) 102 (5,096) 2325 (2,771) 12 $12.7� ) (1,387) (358) 120) 2,066 �954) 1,112 (12) � $� � �— $� TIME WARNER INC. SUPPLEMENTARY INFORMATION CONDENSED CONSOLIDATING FINANCIAL STATEMENTS--(Continued) (unaudited) Consolidating Statement of Operations For The Nine Months Ended September 30, 1998 Non- Time Time TW Guarantor Elimina- Warner Warner Comoanies TBS Subsidiaries tions Consolidated (millions) Revenues ..................................................... $ - $ - $542 $9.861 $ 16) 10 38� Cost ofrevenues (1) ...................................... - - (244) (5,788) 16 (6,016) Selling, general and administrarive (1) ......... _ = 142) f 3,360) _ !3•502) Operating expenses ....................................... _ = 386) 9 148) 16 �518) Business segment operatiag income ............. - - 156 713 - 869 Equiry in pretax income of consolidated subsidiaries ..................... . 486 949 165 - (1,600) - ......................... Equity in pretax income of Entertainmeat Group ...................................................... - - - 492 (55) 437 Interest aad other, net ................................... (57) (570) (121) (91) (38) (877) Corporate expenses ....................................... L) �) 11 �) 97 �) Income before income taxes ......................... 371 339 189 1,068 (1,596) 371 Income tax provisioa .................................... L) L) L) (599) 963 (293) Net income ................................................... �7$ �142 � �4 �) $ 78 (1) Ineludes depreciation and amortizadon expense of ............................................................ � � �!t 5.�. � S 884 33 TIME WARNER INC. SUPPLEMENTARY INFORMATION CONDENSED CONSOLIDATING FINAIVCIAL STATEMENTS--{Continued) (unaudited) Consolidating Balance Sheet September 30, 1999 Non- Time Time TW Guaranror Elimina- Warner Warner Comnanies TBS Subsidiaries tions Consolidated (millions) ASSETS Current assets Cash and equivalents ............................................................. $ - $ 1 $ 15 $ 629 $ - $ 645 Receivables, net ..................................................................... 6 27 92 4,065 - 4,190 Inventones............................................................................. - - 150 2,045 - 2,195 Prepaid expenses ................................................................... 57 _ = 1.513 = 1.570 Total current assets ................................................................ 63 28 257 8,252 - 8,600 Noncurrent inventories ..............:. .......................................... - - Investments in and amounu due to and from consolidated subsidiaries ................................................... 15,810 15,474 Other investtnents ........:......................................................... 210 8 Property, Plant and equipment ............................................... 39 Music catalogues, con�acts and copyrights ........................... - - Cable television and sports franchises ................................... - - Goodwill................................................................................ - - Otherassets ............................................................................ 99 104 175 3,767 - 3,942 9,361 - (40,645) - 24 2,167 (707) 1,702 44 8,406 - 8,489 - 802 - 802 - 7,863 - 7,863 - 15,377 - 15,377 65 1389 _ 1.657 Totalassets ..........................................................................••� � � � �) 4 4 LIABILII'IES AND SHAREHOLDERS' EQUITY Current liabilities Accountspayable ................................................................... $ 25 Participations, royalries and programming costs payable.............................................................................. - Debt due within one year ....................................................... - Other current liabilities .......................................................... 295 $ - $ 5 $ 1,426 $ - $ 1,456 - 38 2,827 - 2,865 - - 26 - 26 106 151 3,938 �261) 4,229 Total current liabiliries ........................................................... 320 106 194 8,217 (261) 8,576 Long-term debt ..................................................................... 1,585 Debt due to affiliates ................................................:............ - Boaowings against future stock option proceeds .................. 1,230 Deferred income taxes ........................................................... 3,848 Uneamed portion of paid subscriprioas ................................. - Other liabilities ...................................................................... 452 Minoriry interests ................................................................... - TW Companies-obligated mandatorily redeemable prefened securities of subsidiaries holding solely debentures of TW Companies ........................................... - 6,802 3,661 747 1,647 267 156 8,678 - 17,812 158 (1,805) - - - 1,230 3,928 (7,856) 3,848 742 - 742 3,080 - 3,688 3,175 - 3,175 - 575 - 575 Shareholders' equity Due from Time Waraer and subsidiaries ............................... -(2,293) (752) (3,450) 6,495 - Other shareholders' equity ..................................................... 8.786 7.338 7.667 22.920 3( 7.925) 8.786 Total shareholders' equity ...................................................... 8.786 5,045 6.915 19.470 31 430) 8.786 Total liabilities and shareholders' equity ................................� $15 4�$4� ��) 4 4� 34 TIME WARNER INC. SUPPLEMENTARY INFOR'�IATION CONDENSED CONSOLIDATING FINANCIAL STATEMENTS--{Continued) (unaudited) Consolidating Balance Sheet December 31, 1998 Non- Time 'f'ime TW Guarantur Elimina- Warner Warner Comoanies TBS Subsidiaries tions Consolidated (miifions) ASSETS Current assets Cash and equivalents ............................................................. $ - $ 66 $ 25 $ 351 $ - $ 442 Receivables, net ..................................................................... 10 56 78 2,750 (9) 2,885 Inventories ............................................................................. - - 131 815 - 946 Prepaid expenses ................................................................... 17 5 - 1.166 �) 1.176 Total current asseu ................................................................ 27 127 234 5,082 (21) 5,449 Noncurrent inventories .......................................................... - - Investmeats in and amounts due to and from consolidated subsidiaries ................................................... 15,222 13,745 Inves�nu in and a�unts due to and from Entertainment Group ................................................. - 919 Other invesunenu .................................................................. 211 15 Property> Plant and equipment ............................................... 55 - Music catalogues, con�acu and copyrights ........................... - - Cable television and sports franchises ................................... - - Goodwill................................................................................ - - Otherassets ............................................................................ 65 116 156 1,744 - 9,465 - (38,432) - 4,169 24 1,194 44 1,892 - 876 - 2,868 - 11,919 59 631 1,900 (108) 4,980 (650) 794 - 1,991 - 876 - 2,868 - 11,919 �) 863 Total assets ............................................................................$15_580 � � � �) � LIABILITIES AND SHAREHOLDERS' EQUITY Current tiabilities Accounts payable ................................................................... $ 20 Participations, royalties and progranuning costs payable.............................................................................. - Debt due within one year ....................................................... - Other current liabilities .......................................................... 308 $ - $ 11 $ 965 $ - $ 996 - 31 1,168 - - 19 229 176 1.705 Total current liabilities ........................................................... 328 229 218 3,857 Long-term debt ..................................................................... 1,584 Debt due to affiliates ............................................................. - Borrowings against future stock option proceeds .................. 895 Defeired iacome taxes ........................................................... 3,491 Unearned portion of paid subscripdons ................................. - Other liabilities ...................................................................... 430 TW Companies-obligated maadatorily redeemable prefeired securities of a subsidiary holding solely subordinated debentures of TW Co�anies ........................................... - 7,346 3,324 - 1,199 - 19 �14) 2.404 (14) 4,618 747 1,248 - 10,925 1,647 158 (1,805) - - - - 895 246 3,570 (7,140) 3,491 - 741 - 741 116 997 - 1,543 - 575 - 575 Shareholders' equity Due from Time Warner and subsidiaries ............................... -(2,313) (479) (2,317) 5,109 - Other shareholders' equiry ..................................................... 8.852 6336 7,487 21.546 35 369) 8.852 Total shareholders' equity ...................................................... 8.852 4.023 7.008 19.229 30 260) 8.852 Total liabilities and shareholders' equity ..............................•-$1.� !�.L� $ Z$� �$(39.1� � 35 TIME WARNER INC. SUPPLEMENTARY I1�iFORMATION CONDENSED CONSOLIDATING FINANCIAL STATEMENTS--{Continued) (unaudited) Consolidating Statement of Cash Flows For The Nine Months Ended September 30, 1999 Time TW Warner am anies OPERATIONS Netincome.......................................................:.................... $1,100 $1,055 Adjus�nents for noncash and nonoperating items: Extraordinary loss on retirement of debt ............................... 12 12 Depreciarion and amortizarion ............................................... - - Noncash interest expense ....................................................... - 3 Excess (deficiency) of dis�ibutions over equity in pretax income of consolidated subsidiaries ....................... (756) (511) Changes in operating assets and liabiliries ............................. 101) 141) Cash provided by operations ................................................. INVESTING ACTIVITIES Consolidation of the Entertainment Group's cash and equivalents......................................................................... Investinents and acquisitions ................................................. Advances to pazents and consolidated subsidiaries ............... Repayment of advances from consolidated subsidiaries........ Capital expenditures .............................................................. Investrnent proceeds .............................................................. Noo- Time Guaraotor Elimiaa. Waroer TBS Subsidiaries tions Consolidated (milliom) $ 177 $1,527 $(2,759) $1,100 - - (12) 12 7 1,846 - 1,853 - - - 3 14 - 1,253 - 74 685 (683) (166) 255 418 272 4.058 2 201) 2.802 - 107 - 87 - 87 - (423) - (423) - (1,153) 1,153 - - 232 (339) - (9) (1,523) - (1,532) = 476 = 476 Cash provided (used) by investing acrivities ......................... _ . 107 �) 2 304) 814 1 392) FINANCING ACTIVITIES Boaowings............................................................................ - 1,978 - 1,149 - 3,127 Debt repayments .................................................................... - (2,567) - (244) - (2,811) Change in due to/from parent ................................................ 922 20 (273) (2,056) 1,387 - Boaowings agaiast future stock oprion proceeds .................. 335 - - - - 335 Redemption of mandatorily redeemable preferred securities of subsidiary ...................................................... - - - (217) - (217) Repurchases ofTime Waraer comrtton stock ......................... (1,636) - - - -(1,636) Dividendspaid ....................................................................... (226) - - - - (226) Proceeds received from stock oprion and dividend reinves�ent plans .............................................. 350 - - - - 350 Other...................................................................................... - _._L) — �g) — 129 Cash used by financing acrivities ........................................... 255) (590) 273) 1 476) 1.387 1 207 INCREASE (DECREASE) IN CASH AND EQLTIVALENTS ............................................................... — —L?) 10 278 - 203 CASH AND EQUIVALENTS AT BEGINNING OF PERIOD ............................................. - 66 25 351 - 442 CASH AND EQUIVALENTS AT END OF PERIOD ....... � $ 1 $ 15 � ��.� 36 TIME WARNER INC. SUPPLEMENTARY INFORMATION CONDENSED CONSOLIDATING FINANCIAL STATEMENTS—(Continued) (unaudited) Consolidating Statement of Cash Flows For The Nine Months Ended September 30, 1998 tioo- Time Time TW Guaraotor Elimioa- Warner W'arner om a ies TBS Subsidiaries tions Consolidated (millions) OPERATIONS Net income ............................................................................ $ 78 $102 $ 62 $469 $(633j $ 78 Adjustmenu for noncash and nonoperating items: Depreciation and amortizarion ............................................... - - 6 878 - 884 Noncash interest expense ....................................................... - 29 - - - 29 Excess (deficiency) of distriburions over equity in pretaxincomeofconsolidatedsubsidiaries ....................... 1,140 (467) 335 - (1,008) - Excess of disuibutions over equity in pretax income of Entertainment Group ......................................................... - - - 113 55 168 Changes in operating assets and liabilities ............................. 472 5 �125) L) 184) 35 Cash provided (used) by operations ...................................... 1.690 L1) 278 1.227 (1.670) 1,194 INVESTING ACTIVITIES Inves�nenu and acquisitions ................................................. (213) - - 127 - (86) Advances to pazents and consolidated subsidiaries ............... (873) (187) - (39) 1,099 - Repayment of advances from consolidated subsidiaries........ 75 360 - - (435) - Capital expenditures .............................................................. - - (9) (339) - (348) Inves�nentproceeds .............................................................. - - - 458 - 458 Proceeds received from distribution of TWE Senior Capital............................................................................... - - - 455 - 455 Cash provided (used) by investing activities ......................... 1 O 11) 173 �) 662 664 479 FINANCING ACTIVITIES Borrowings ............................................................................ 601 496 - 579 (7) 1,669 Debtrepayments .................................................................... - (500) (75) (1,800) 75 (2,300) Change in due to/frompazent ................................................ - (188) (192) (558) 938 - Boaowings against future stock opaon proceeds .................. 1,015 - - - - 1,015 Repayments of boaowings against future stock option proceeds ................................••-.............................. (533) - - - - (533) Repurchases of Ti� Warner com�n stock ......................... (1,944) - - - -(1,944) Dividends paid ....................................................................... (394) - - - - (394) Proceeds received �om stock options and dividend reinvestrnent plans ............................................................. 599 - - - - 599 Other...................................................................................... �) 14) - - - �) Cash used by financing acuvities ........................................... 679 l2061 �) 1 779) 1.006 1 925) INCREASE (DECREASE) IN CASH AND EQUIVALENTS ............................................................... _ L64) 2 110 = �) CASH AND EQUIVALENTS AT BEGINNING OF PERIOD ............................................. = 372 9 264 = 645 CASH AND EQUIVALENTS AT END OF PERIOD ....... � $$ � $ 374 � � 37 TIME WARPIER ENTERTAINMENT COMPANY, L.P. MANAGEMENT'S DISCUSSIOI�' AND AIVALYSIS OF RESULTS OF OPERATIONS AND FINANCIAL CONDITION Description of Business Time Wamer Entertainment Company, L.P. ("TWE" or the "Company") classifies its business interesu into three fundamental areas: Cable Networks, consisting principally of interests in cable television programming; Filmed Entertainment, consisting principally of iaterests in filmed entertainment, television producrion and television broadcasting; and Cable, consisting principally of iaterests in cable television systems. TWE also manages the cable properties owned by Time Wamer and the combined cable television operarions aze conducted under the name of Time Warner Cable. Use of EBITA TWE evaluates operating performance based on several factors, including its primary financial measure of operating income before noncash amortizarion of intangible assets ("EBITA"). Consistent with management's financial focus on con�olling capital spending, EBITA measures operating performance after charges for depreciation. In addition, EBITA elirainates the uneven effect across all business segmenu of considerable amounts of noncash amortization of intangible assets recognized in business combinarions accounted for by the purchase method. These business combinarions, including Time Waraer's $14 billion acquisition of Warner Communicarions Inc. in 1989 aad $1.3 billion acquisirion of the minoriry interest in American Television and Communicarions Corporarion in 1992, created over $10 billion of intangible assets that generally are being amortized over a twenry to forty year period. The exclusion of noncash amorrizarion charges is also consistent with management's belief that TWE's intangible asseu, such as cable television franchises, film and television libraries and the goodwill associated with its brands, generally aze increasing in value and importance to TWE's business objective of creating, extending and distiibuting recognizable brands and copyrights throughout the world. As such, the following com�ararive discussion of the results of operations of TWE includes, auiong other factors, an anaiysis of changes in business segment EBITA. However, EBTTA should be considered in addition to, not as a substitute for, operating income, net income and other measures of financial perfom�ance reported in accordance with generally accepted accounting principles. AT&T MediaOne Merger At the time of this filing, MediaOne Group, Inc. ("MediaOne"), a liauted partaer in TWE, had agreed to be acquired by AT&T Corp. ("AT&T"). In August 1999, 'TWE received a notice from MediaOne conceming the teimination of its covenant not to compete with TWE. The termination of that covenant is necessary for MediaOne to complete its proposed merger with AT&T. As a result of the terminarion norice and the operation of �e TWE partnership agreement, MediaOne's rights to participate in the management of TWE's businesses terminated immediately and irrevocably. MediaOne retains only certain protective governance righu pertaining to certain limited matters affecting 1'WE as a whole. The proposed merger of MediaOne and AT&T is subject to customary closing conditions, including regulatory approvals. Accordingly, there is no assurance that it will occur. Also, there are no assurances that AT&T and Time Warner will reach final agreement on the terms of a cable telephony joint venture, either on the tem�s discussed on page F-8 of TWE's Annual Report on Form 10-K for the yeaz ended December 31, 1998, or on any alternative terms. Transactions Affecting Comparability of Results of Operations As more fully described herein, the comparability of TWE's operaring results has been affected by certain significant �ansacrions and nonrecurring items in each period. 38 TIME WARNER ENTERTAINMENT COMPAI�Y, L.P. MANAGEMENT'S DISCUSSION AND ANALYSIS OF RESIJLTS OF OPERATIONS AND FINANCIAL CONDITION—�Continued) In 1999, these nonrecurring items consisted of (i) an approximate $215 million net pretax gain recognized in the first quarter of 1999 in connecrion with the early temvnarion and settlement of a long-term home video dis�ibution agreement and (ii) net pretax gains in the amount of $1.118 billion recognized in the first nine months of 1999 relating to the sale or exchange of various cable television systems and investments. This co�ares to net pretax gains recognized in the first nine months of 1998 of $90 million relating to the sale or exchange of cable television systems. In order to meaningfully assess imderlying operating uends, management believes that the results of operations for each period should be analyzed afrer excluding the effecu of these significant nonrecurring gains. As such, the following discussion and analysis focuses on amounts and trends adjusted to exclude the impact of these unusual items. However, unusual items may occur in any period. Accordingly, investors and other financial statement users individually should consider the rypes of evenu and �ansactions for which adjusunenu have been made. In addiuon, the cott�arabiliry of TWE's Cable division results has been affected further by certain 1998 cable- related transacrions, as described more fully in Note 8 to the accompanying consolidated financial statemenu. While these �ansacrions had a significaat effect on the comparabiliry of the Cable division's EBITA and operating income priacipally due to the deconsolidation of the related operations, they did not have a significant effect on the co�azabiliry of T'WE's net income. RESULTS OF OPERATIONS EBITA aad operating income aze as follows: Filmed Entertainment-Warner Bros �� ......................... Broadcasting-The WB Network .................................. Cable Networks-HBO .................................................. Cable�2� ........................................................................ Three Moaths Eaded Seotember 30, Nine Months Ended Seutember 30. Openting Openting EBITA Income EBiTA Income 1� 9� 1999 1998 1999 1� 1999 1998 (millions) $180 $161 5150 $128 $ 658 $ 401 $ 567 $ 302 �24) �17) �2S) �17) �95) i78) �98) �80) 138 117 138 117 394 334 394 339 699 336 600 240 2.135 1.017 1.863 731 Total .................................................................•-.......... �22� $S2Z � �$ � $ � � � (1) Includes a net pretax gain of approximatety 5215 million recogriud in the first quarter of 1999 in cormection with the early temiination and settlement of a long-tam home video dutr�bution ageert�a�t (2) Includes net pretax gains nlating to the sak ar exciange of artain cabk tekvisia� sysrcms and 'mvamxnts of 5358 million in the third quarter of 1999 and 56 millia� in the di'u�d quarter of 1998. Siatilarty, nine-rt�mth iesults include na pretax gduu of S 1.118 billion in 1999 and $90 million in 1998. Three Months Ended September 30,1999 Compared to the Three Months Ended September 30,1998 Consolidated ResWts TWE had revenues of $3.474 billion and net income of $561 �llion for the three �nths ended September 30, 1999, compared to revenues of $3Z20 billion and net income of $172 millioa for the three months eaded September 30, 1998. As previously described, the comparabiliry of TWE's operating results for 1999 and 1998 bas been affected by certain significant, nonrecurring items recognized in each period. These nonrecurring items consisted of approximately $358 million of net pretax gains ia 1999, compazed to $6 million of net pretax gains ia 1998. 39 TIME WARNER ENTERTAINMENT COMPANY, L.P. MANAGEMENT'S DISCUSSION AND APiALYSIS OF RESULTS OF OPERATIONS AND FINANCIAL CONDITION—�Continued) TWE's net income increased to $561 million in 1999, corr�azed to $172 million in 1998. However, excluding the effect of the nonrecurring items referred to earlier, net income increased by $54 million to $220 million in 1999 from $166 million in 1998. As discussed more fully below, this improvement principally resulted from an overall increase in TWE's business segment operating income. As a U.S. partnership, TWE is not subject to U.S. federal and state income taxation. Income and withholding taxes of $39 million and $23 million for the three months ended September 30, 1999 and 1998, respecrively, have been provided for the operarions of TWE's domestic and foreign subsidiary corporations. Business Segment Results Filmed Entertainment-Warner Bros. Revenues increased to $1.862 billion in 1999, compared to $1.727 billion in 1998. EBITA increased to $180 million in 1999 from $161 million in 1998. Operating income increased to $150 million in 1999 from $128 million in 1998. Revenues benefited from increases in worldwide theatrical, home video and television syadication operations, offset in part by lower revenues from consumer producu operations. The increase in worldwide home video revenues primarily resulted from increased sales of DVDs. EBITA and operating income increased principally as a result of improved results from worldwide theati-ical, home video and television syndication operations, offset in part by lower results from consumer products operations. In connection with declines in the operarions of certain of Wamer Bros.'s retail stores, management is in the process of evaluating several s�ategic alternarives for its retail operations. These alternarives include the gradual reducrion and updating of Warner Bros.'s store portfolio, including the transformation of some of the �aditional retail outlets to smaller, more efficient stores and an increasing emphasis on e-commerce oppominities. To the extent managemeat takes acrion under some of these alternarives, a non-cash charge, principally relating to the accelerarion of future depreciation expense, may be required. Management's evaluation is expected to continue through the 1999 holiday shopping season. Bnoadcasting - The WB Network Revenues were $84 million in 1999, compared to $64 million in 1998. EBITA decreased to a loss of $24 million in 1999 from a loss of $17 million in 1998. Operating losses increased to $25 million in 1999 from $17 million in 1998. Revenues increased principally as a result of one additional night of weekly pnme- time programming in comparison to the prior yeaz and advertising rate increases, offset in part by lower television ratings for the summer repeat programming lineup. Operating losses increased principally because the revenue gains were more . than offset by the combination of higher prograauning costs associated with the expanded programming schedule and higher start-up costs associated with The WB Network 100+ starion group, a dishzbution alliance for The WB Network in smaller mazkets. Cable Networks-HBO. Revenues increased to $540 million in 1999, compazed to $505 million in 1998. EBITA and operating income increased to $138 million in 1999 from $117 million in 1998. Revenues benefited primarily from an increase in pay-television subscriptions. EBITA and operating income increased principally due to the revenue gains and increased cost savings. Cable. Revenues increased to $1.124 billion in 1999, compazed to $1.052 billion in 1998. EBITA increased to $699 million in 1999 from $336 million in 1998. Operating income increased to $600 million in 1999 from $240 million in 1998. These operating results were affected by certain cable-related �ansacrions that occurred in 1998 (the "1998 Cable Transactions") and by net pretax gains of $358 million recognized in 1999 and $6 million in 1998 related to the sale or exchange of various cable television systems and investmeats. The 1998 Cable Transactions principally resulted in the deconsolidation or tiansfer of certain operations and are described more fully in Note 8 to the accompanying consolidated financial statements. Excluding the effect of the 1998 Cable Transactions, revenues increased due to growth 40 TIME WARNER ENTERTAINMENT COMPANY, L.P. MANAGEMENT'S DISCUSSION AND ANALYSIS OF RESULTS OF OPERATTONS AND FINANCIAL CONDITION—{Continued) in basic cable subscribers, increases in basic cable rates, increases in advertising and pay-per-view revenues and an increase in revenues from providing Road Runner-branded, high-speed online services. Sirnilarly, excluding the effect of the 1998 Cable Transacrions and the one-time gains, EBITA and operating income increased principally as a result of the revenue increases, offset in part by higher programming cosu. Interest and Other, Net. Interest and other, net, decreased to $185 million of expense in 1999, cor�azed to $203 million of expense in 1998. Interest expense decreased to $138 million in 1999, co�azed to $145 million in 1998, prin- cipally due to iaterest savings associated with the Company's 1998 debt reducrion efforts. Other expense, net,-decreased to $47 million in 1999, compazed to $58 million in 1998. The decrease principally related to lower dividend reguirements on prefeaed stock of a subsidiary that was redeemed in March 1999. Minoriry Interest. Minonty interest expense increased to $60 million in 1999, compazed to $52 million in 1998. Minoriry interest expense increased primarily due to the allocation of a portion of the net pretax gains relating to the sale or exchange of various cable television systems and investmenu owned by the TWE-Advance/Newhouse Parniership ("TWE-A/N"), a majority owaed partnership of TWE, to the minoriry owners of that parmership. Excluding the significant effect of the gains recognized in 1999, minority interest expense decreased slightly in 1999 principally due to a lugher allocation of losses to a minoriry parmer in T'he WB Network. Nine Months Ended September 30,1999 Compared to the Nine Months Ended September 30, 1998 Consolidated Results TWE had revenues of $9.468 billion aad net income of $1.640 billion for the nine months ended September 30, 1999, compared to revenues of $8.980 billion and net income of $435 million for the nine months ended September 30, 1998. As previously described, the comparabiliry of TWE's operating resulu for 1999 and 1998 has been affected by certain signi5cant, nonrecurring items recognized in each period. These nonrecurring items consisted of approximately $1333 billion of net pretax gains in 1999, compazed to $90 million of net pretax gains in 1998. TWE's net income increased to $1.640 billion in 1999, compared to $435 million in 1998. However, excluding the significant effect of the nonrecurriag items referred to earlier, net iacome increased by $117 million to $482 million in 1999 &om $365 million in 1998. As more fully discussed below, this impmvemeat principally resulted from an overall increase in TWE's business segment operating income, offset in part by higher equiry losses from certain investments accounted for under the equity method of accoimting. As a U.S. partnerslup, TWE is not subject to U.S. federal and state income taxation. Income and withholding taxes of $94 million and $55 million for the nine months ended September 30, 1999 and 1998, respectively, have been provided for the operations of TWE's domesric and foreign subsidiary corporations. Business Segment Results Filmed Enrertainneent-Warner Bms. Revenues increased to $4.688 billion in 1999, compared to $4.364 billion in 1998. EBITA increased to $658 million in 1999 from $401 million in 1998. Operating income increased to $567 million in 1999 from $302 million in 1998. Revenues benefited from increases in worldwide thea�ical, home video and television dis�ibution opentions, offset in part by lower revenues from consumer producu operations. The increase in worldwide home video revenues primarily resulted from increased sales of DVDs. EBITA and operating iacome increased primarily from the inclusion of an approximate $215 million net pretax gain recognized in the first quarter of 1999 in connection with the early termination and settlement of a long-term home video distribution agreement. 41 TIME WARivER ENTERTAINMENT COMPANY, L.P. MANAGEMENT'S DISCUSSION AND Al\AI,ySIS OF RESITLTS OF OPERATIONS AND FINANCIAL CONDITION—tContinued) Excluding the gain, EBITA and operating income increased principally as a result of improved results from worldwide theatrical, home video and television distribution operations, of�'set in part by lower results from consumer products opentions. In connection with declines in the operations of certain of Wamer Bros.'s retail stores, management is in the process of evaluating several strategic altematives for its retail operations. These alternarives include the gradual reduction and updating of Warner Bros.'s store portfolio, including the �ansformarion of some of the traditional retail outlets to smaller, more efficient stores and an increasing emphasis on e-commerce opportuniries. To the extent management takes acrion under some of these alternatives, a non-cash charge, principally relaring to the accelerarion of future depreciarion expense, may be required. Management's evaluation is expected to continue through the 1999 holiday shopping season. Broadcasting - The WB Network. Revenues were $246 million in 1999, compazed to $170 million in 1998. EBITA decreased to a loss of $95 million in 1999 from a loss of $78 million in 1998. Operating losses increased to $98 millioa in 1999 from $80 million ia 1998. Revenues increased principally as a result of one addirional night of weekly prime-time programming in comparison to the prior yeaz, improved television ratings and advertising rate increases. Operatiag losses increased principally because the revenue gains were more than offset by the combinarion of higher programming costs associated with the expanded programrning schedule and higher start-up cosu associated with The WB Network 100+ starion group, a distiiburion alliance for The WB Network in smaller markets. Cable Networks-HBO. Revenues increased to $1.612 billion in 1999, compared to $1.526 billion in 1998. EBITA and operating income increased to $394 million in 1999 �om $339 million in 1998. Revenues benefited primarily from an increase in pay-television subscriptions. EBITA and operating income increased principally due to the revenue gains, increased cost savings, and higher income from Comedy Central, a SO%-owaed equity investee. Cable. Revenues increased to $3312 billion in 1999, com�ared to $3.289 billion in 1998. EBITA increased to $2.135 billion in 1999 from $1.017 billion in 1998. Operating income increased to $1.863 billion in 1999 from $731 million ia 1998. These operating results were affected by the 1998 Cable Transacrions and by net pretax gains of $1.118 billion recognized in 1999 and $90 aullion in 1998 related to the sale or exchaage of various cable television systems and investments. The 1998 Cable Transactions principally resulted in the deconsolidation or transfer of certain operarions and are described more fully in Note 8 to the accompanying consolidated financial statemeats. Excluding the effect of the 1998 Cable Transactions, revenues increased due to growth in basic cable subscribeis, increases in basic cable rates, increases in advertising aad pay-per-view revenues and an increase in revenues from providing Road Runner-branded, high-speed online services. Similariy, excludiag the effect of the 1998 Cable Transactions and the one-time gains, EBITA aad operating incoa�e increased principally as a result of the revenue increases, offset in part by higher programming costs. Interest and Other, Net Interest and other, ne� increased to $577 million of expense in 1999, com�azed to $550 million of expense in 1998. Interest expense decreased to $411 million in 1999, compared to $418 million in 1998, principally due to interest savings associated with the Company's 1998 debt reducrion efforts. Other expense, net, increased to $166 million in 1999, compazed to $132 million in 1998. This increase principally related to higher losses from certain investinents accounted for under the equity method of accounting, offset in part by lower dividend requirements on prefeaed stock of a subsidiary that was redeemed in March 1999. Minority Interest. Minority interest expense increased to $361 million in 1999, compazed to $198 million in 1998. Minority interest expense increased primarily due to the allocation of a portion of the net pretax gains relating to the sale or exchange of various cable television systems and investinents owned by TWE-A/N to the minonry owners 42 TIME WARNER ENTERTAINMENT COMPANY, L.P. MANAGEMENT'S DISCUSSION AND ANALYSIS OF RESULTS OF OPERATIONS AND FINANCIAL CONDITION—(Continued) of that parniership. Excluding the significant effect of the gains recognized in each period, minority interest expense decreased slightly in 1999 principally due to a higher aliocation of losses to a minoriry partner in The WB Network. FINANCIAL CONDITION AND LIQUIDITY September 30,1999 Financia! Condition At September 30, 1999, TWE had $6.7 billion of debt, $235 million of cash and equivalents (net debt of $6.5 billion) and $6.3 billion of parniers' capital. This compazes to $6.6 billion of debt, $87 million of cash and equivalents (net debt of $6.5 billion), $217 million of preferred stock of a subsidiary, $603 arillion of Tur�e Wazner General Parmers' senior priority capital and $5.1 billion of paroners' capital at December 31, 1998. Senior Capital Distributions In July 1999, TWE paid a$627 million distribution to the Time Wazaer General Parmers to redeem the remaining portion of their senior priority capital iaterests, including a priority capital ret�un of $173 millioa. Time Warner used a portion of the proceeds received from this dis�bution to repay all $400 million of outstanding boirowings under its credit agreement with TWE. Redeniption ojREIT Preferred Stock In March 1999, a subsidiary of TWE (the "REIT"') redeemed all of iu shares of prefeaed stock ("REIT Prefeired Stock") at an aggregate cost of $217 million, wlrich approximated net book value. The redemptioa was funded with boaowings under TWE's bank credit agreemeat Pursuant to its terms, the RETT Prefeaed Stock was redeemed as a result of proposed changes to federal tax regulations that substantially increased ihe lilcelihood that dividends paid by the REIT or interest paid to the REIT under a mortgage note of TWE would not be fully deducrible for federal iacome tax purposes. Cash Flows During the first nine �nths of 1999, TWE's cash provided by operations amounted to $2.205 billion and reflected $3.092 billioa of EBTTA from iu Filmed Entert�ent-Warner Bros., Broadcasting-The WB Network, Cable Networlcs-HBO and Cable businesses, $632 arillion of noncash deprxiation expense and $20 million of proceeds from TWE's asset securitization program, less $394 million of interest payments, $84 million of income taxes, $54 million of corporate expenses, and $1.007 billion related to an aggregate increase in working capital requirements, other balance sheet accounts and noacash items. Cash provided by operations of $1.273 billion in the first nine months of 1998 reflected $1.679 billion of EBTTA from its Filmed Entertainment-Warner Bros., Broadcasring-The WB Network, Cable Networks-HBO and Cable businesses, $698 million of noncash depreciation expense and $131 arillion of proceeds from TWE's asset securiti2arion program, less $419 million of interest payment�, $57 million of income taxes, $54 million of coipocate expenses and $705 million related to an aggregate increase in worldng capital requirements, other balance sheet accounts and aoncash items. Cash used by investing activities was $540 million in the first nine months of 1999, compared to $887 million in the first nine months of 1998. The decrease priacipally resulted from the collection of TWE's $400 million loan to Time Warner and lower capital expeaditures, offset in part by a$198 million decrease in inves�nent pmceeds relating largely to the 1998 sale of TWE's remaining interest in Six Flags Entertainment Corporation. Capital expenditures decreased to $1.009 billion in the first nine months of 1999, compared to $1.092 billion in the fust nine months of 1998. 43 TIME WARNER ENTERTAINMENT COMPANY, L.P. MANAGEMENT'S DISCUSSION AND ANALYSIS OF RESIJLTS OF OPERATIONS AND FINqNCIAL CONDITION--(Continued) Cash used by financing activities was $1.517 billion in the fust nine months of 1999, corr�ared to $583 million in the first nine months of 1998. The use of cash in 1999 principally resulted from the redemption of REIT Preferred Stock at an aggregate cost of $217 million, the payment of $1.116 billion of capital dis�iburions to Time Wamer and $39 million of debt reduction. The use of cash in 1998 principally resulted from the payment of $1.060 billion of capital distiiburions to Time Warner, offset in part by an $675 million increase in net boaowings. Management believes that TWE's operating cash flow, cash and equivalents and additional boaowing capacity are sufficient to fuad its capital and liquidity needs for the foreseeable future. ' Cable Capital Spending Time Warner Cable has been engaged in a plan to upgrade the technological capability and reliability of its cable television systems and develop new services, which it believes will position the business for sustained, long-term growth. Capital spending by TWE's Cable division amounted to $910 million in the nine months ended September 30, 1999, compazed to $991 million in the nine months ended September 30, 1998. Cable capital spending is expected to approximate $350 million for the remainder of 1999. Capital spending by TWE's Cable division is expected to continue to be funded by cable operatiag cash flow. Filmed Entertainment Backlog Backlog represents the amount of future revenue not yet recorded from cash con�acts for the licensing of theatrical and television product for pay cable, basic cable, network and syndicated television exlubirion. Backlog of TWE's Filmed Entertainment-Warner Bros. division amounted to $2.571 billion at September 30, 1999 (including amounts relating to the licensing of film product to TWE's cable television networks of $307 million and to Time Warner's cable television networks of $612 million). This compazes to $2.298 billion at December 31, 1998 (iacluding amounts relating to the licensing of film product to TWE's cable television networks of $199 million and to Time Wamer's cable television networks of $570 million). Becaase backlog generally relates to contracts for the licensing of theatrical and television product which have already been produced, the recognition of revenue for such completed product is principally only dependent upon the coaanencement of the availability period for telecast under the terms of the related licensing agreement. Cash licensing fees aze collected periodically over the term of the related licensing agreements or on an accelezated basis using TWE's $500 million securitization faciliry. The portion of backlog for which cash has not already been received has significant off-balance sheet asset value as a so�ce of future funding. The backlog excludes advertising barter con�acts, which are aLso expected to result in the fiih�re realization of zevenues and cash through the sale of advertising spots received ander such contracts. Year 2000 Technology Preparedness TWE, like most large companies, depends on many different computer systems and other chip-based devices for the continuing conduct of its business. Older computer programs, computer hardware and chip-based devices may fail to recognize dates beginning on January 1, 2000 as being valid dates, and as a result may fail to operate or may operate improperly when such dates aze in�oduced. TWE's exposure to potendal Yeaz 2000 problems arises both in technological operarions under the control of the Company and in those dependent on one or more third parties. These technological operations include information technology ("IT") systems and non-TT systems, including those with embedded technology, hardware and sof�vvare. Most of TWE's potential Yeaz 2000 exposures aze dependent to some degree on one or more third parties. Failure to achieve high levels of Yeaz 2000 compliance could have a material adverse impact on TWE and its financial statements. ' 44 TIME WARNER ENTERTAINMENT COMPAl`'Y, L.P. MANAGEMENT'S DISCUSSION AND AIVALYSIS OF RESULTS OF OPERATIONS AND FTNANCIAL CONDITION--{Continued) The Company's Yeaz 2000 iniriarive continues to be conducted at the operational level by divisional project managers and senior technology executives overseen by senior divisional executives, with assistance internally as well as from ouuide professionals. The progress of each division through the difi'erent phases of remediation—inventorying, assessment, remediation planning, implementarion and fmal testing—is acrively overseen and reviewed on a regular basis by an executive oversight group. The Company, initially identified and assessed potenrial Year 2000 d�culties in iu technological operations, including TT applications, IT technology and support, desktop hardware and sof�ware, non-TT systems and i�ortant third party operations, and distinguished those that are "mission critical" from those that are not. An item is considered "mission critical" if its Yeaz 2000-related failure would significandy impair the abiliry of one of the Company's major business units to (1) produce, market and dis�ibute the products or services that generate significant revenues for that business, (2) meet its obligations to pay its employees, aztisu, vendors and others or (3) meet its obligarions under regulatory requirements and iaternal accounting con�ols. The Co�any and its divisions have identified approximately 600 worldwide, "mission critical" potential exposures. As of September 30, 1999, substantially all of the potential exposures have been identified by the divisions as Year 2000 compliant and of those that are not reported as compliant, substanrially all were in the installation or final testing stages and expected to be substantially co�leted in all material respects by the middle of the fourth quarter of 1999. The Company, however, could experience unexpected delays. The Company is expecting to focus its attention during the fourth quarter of 1999 on conductiag final integrated testing in a stable environment and on refinements and testing of its contingency and transition plans, as necessary. As stated above, however, the Compan}�s business is heavily dependent on third parties, both domestically and internarionally, aad these parties aze themselves heavily dependent on technology. For example, if a television broadcaster or cable programiner encounters Yeaz 2000 problems that iu�ede its ability to deliver its programming, the Company will be unable to provide that programming to its cable customers. Because the Company is also a programming supplier, third-party signal delivery problems would affect iu abiliry to deliver its progranuning to its customers. In additioq in a sitvation endemic to the cable industry, much of the Compan�s headend equipment that coatrols cable set-top boxes needed to be upgraded to become Yeaz 2000 co�liaat The box manufacturers and cable indastry groups together developed solutions that the Company has substantially completed installing and testing in its headend equipment at its vazious geog�apluc locations. The Company has attempted to iaclude in its "mission critical" inventory significant service providers, vendors, suppliers, customers and goveramental eatities that are believed to be critical to business operations and bas made its determinations of their state of Year 2000 readiness ti�rough various means, including questionnaires, interviews, on-site visits, system inte,rface tesang and iadustry group participation. The Company continues to monitor these situations. Moreover, T'WE is dependeat, like all ]arge coa�anies, on the contiaued fimctioning, domestically aad intemationally, of basic, heavily coa�uterized services such as banking, telephony, water and power, aad various dis�ibution mechanisms ranging from the a�ail, railroads and trucking to high-speed data �ansmission. TWE is taldng steps to attempt to satisfy iuelf that the third pardes on which it is heavily reliant are Year 2000 compliant, aze developing satisfactory contiagency plans or that alternate means of ineeting its requirements aze available, but canaot predict the lilcelihood of such compliance nor the direct or iadirect costc to the Company of non- co�liance by those third parties or of securing such services from alternate compliant third parties. In areas in wluch the Company is uncertain about the anticipated Year 2000 readiness of a si�ificant third party, the Company is investigating available alternatives, if any. The Company ciurendy estimates that the aggregate cost of its Yeaz 2000 remediation program, which started in 1996, wi:l be approximately $50 to $85 million, of which an estimated 75% to 85% has been incurred through September 30, 1999. These cosu include estimates of the cosu of assessment, replacement, repair and upgrade, both planned and u�lanned, of certain TT and non-IT systems and t�ir implementation and testing. The Company anticipates that its remediation program, and relaud expenditures, may continue into 2001 as temporary solurions to Year 2000 45 TIME WARNER ENTERTAINMENT COMPANY, L.P. MANAGEMENT'S DISCUSSION AND ANALYSIS OF RESITLTS OF OPERATIONS AND FINANCIAL CONDITION--(Continued) problems are replaced with upgraded equipment. These expenditures have been and are expected to continue to be funded from the Company's operating cash flow and have not and are not expected to im�act materially the Compan}�s finaacial statemenu. Management believes that it has established an effecrive program to resolve all si�cant Year 2000 issues in its con�ol in a timely manner. As noted above, however, the Company has not yet completed all phases of iu program and is dependent on third parties whose progress is not within its con�ol. In the event that the Company experiences unaaticipated failures of the systems within its control, management believes that the Company could experience significant difficulty ia producing and delivering its products and services and conducting its business in the Year 2000 as it has in the past. More it�ortandy, disruprions experienced by third parties with which the Company does business as well as by the economy generally could materially adversely affect the Company. The amount of potential liability and lost revenue cannot be reasonably estimated at this time. As stated above, the Company is now focusing its attention on its contingency and �ansition plans. It has examiaed its existing standard business interruption s�ategies to evaluate whether they would satisfactorily meet the demands of failures arising from Yeaz 2000-related problems. It is also developing and refining specific transition schedules and contingency plans in the event it does not successfWly complete its remaining remediation as anticipated or experiences unforeseen problems outside the scope of these standard strategies. These plans aze intended to provide guidance and alternatives for unanticipated failures of internal systems as well as external failures that may i�ede any of the Company's businesses from operating normally. The Company intends to examine its status periodically to determine the necessity of implementing such contingency plans or additional strategies, which could involve, among other things, manual workarounds, adjusting staffing s�ategies and sharing resources across divisions. Caution Concerning Forward-Looking Statements The Securities and Exchange Commission encourages companies to disclose forward-looking information so that investors can better understand a company's future prospects and make informed investment decisions. This document, together with management's public commentary related thereto, contains such "forward-looking statements" withia the meaning of the Private Securities Litigatioa Reform Act of 1995, particulazly statements anticipating future growth in revenues, EBITA and cash flow. Words such as "anticipate", "estimate", "expects", "projects", "intends", "plans", "believes" and words and terms of similar substance used 'm connection with any discussion of future operating or 5nancial performance ideatify such forwazd-looldng state�nts. Those foiward-looldng statements aze management's present expectations of future events. As with any projecrion or forecast, they aze inherenfly susceptible to changes in circumstances, and TWE is under no obligation to (and expressly disclaims any such obligation to) update or alter its forward-lookiag statemeats, whether as a result of such changes, new information, future events or otherwise. TWE operates in lrighly com�etitive, consumer driven and npidly changing media and entertainment businesses that aze dependent on government regulation and economic, political, social conditions in the coun�ies in which they operate, consumer demand for their products and services, technological developments and (particulazly in view of technological changes) protecrion of their intellectual properry rights. TWE's actual results could differ materially from management's expectations because of changes in such factors. Some of the other factors that also could cause actual results to differ from those contained in the forward-looldag statements include those identified in TWE's other filings and: • For TWE's cable business, more aggressive than expected competition from new technologies and other types of video progranmiing dis�ibutors, including DBS; increases in govemment regulation of cable or equiprr�ent rates or other tem�s of service (such as "digital must-carry" or `�mbundling" requiremenis); increased difficulty in obtaining franchise reaewals; the failure of new equipment (such as digital set-top boxes) or services (such as high-speed on- 46 TIME WARNER ENTERTAINMENT COMPANY, L.P. MANAGEMENT'S DISCUSSION A1�iD A1rALYSIS OF RESULTS OF OPERATTONS AND FINANCIAL CONDITION-�Continued) line services or telephony over cable or video on demand) to function properly, to appeal to enough consumers or to be available at reasonable prices and to be delivered in a timely fashion; and greater than expected increases in programming or other cosu. • For TWE's cable programming and television businesses, greater than expected programming or production costs; public and cable opentor resistance to price increases (and the negacive impact on premium programmers of increases in basic cable rates); increased regularion of disa�ibution agreements; the sensiriviry of advertising to economic cyclicality; and greater than expected frag�ntation of consumer viewership due to an increased number of progranuning services or the increased popularity of altematives to television. • For TWE's film and television businesses, their abiliry to conrinue to at�act and select desirable talent and scripts at manageable costs; increases in production costs generally; fragmentarion of consumer leisure and entertainment time (and iu possibie negative effects on the broadcast and cable networks, which are significant customers of these businesses); continued popularity of inerchandising; and the uncertain impact of technological developmenu such as DVD and the Intemet • For TWE's digital media businesses, tbeir ability to develop products and services that aze attractive, accessible and commercially viable in terms of content, technology and cost, their ability to manage cosu and generate revenues, aggessive coa�etition from existing and developing technologies and products, the resolurion of issues conceming commercial activities via the Internet, including security, reliabiliry, cost, ease of use and access, and the possibiliry of increased government regularion of new media services. • The ability of the Company and iu key service providers, vendors, suppliers, customers and governmental entiries to replace, modify or upgrade co�uter systems in ways that adequately address the Yeaz 2000 issue, including their abiliry to identify and coaect all relevant computer codes and embedded chips, unanticipated di�culties or delays in the i�lementarion of the Company's remediation plans and the ability of third parties to address adequately their own Yeaz 2000 issues. In addition, TWE's overall financial strategy, including growth in operations, maintaining its financial ratios and strengthened balance sheet, could be adversely affected by increased interest rates, failure to meet earnings expectations, significant acquisitions or other �ansactions, consequences of the euro conversion and changes in TWE's plans, strategies and intentions. 47 TIME WARNER ENTERTAINMENT COMPANY, L.P. CONSOLIDATED BALANCE SHEET (Unaudited) ASSETS Current assets Cash and equivalents ...................... .......... . . . . Receivables, including $1.049 billion and $765 million due from Time Warner, less allowances of $470 and $506 million ................... ......................................................... . ventories ................... ............................................................................................................... Prepaid expenses .................... ............................................................................................... Total current assets ....................................... ............................................................................. Noncurrent inventories ............................................. ............................................................... . .. oan receivable from Time Wamer .................... ........................................................................ Inves�nents .......................................................... ....................................................................... Properry, plant and equipment .............. ...................................................................................... Cable television franchises .................. ....................................................................................... Goodwill ........................................... ............................................................ .............................. ther assets ................................................................................................................................. September 30, December 31, 1999 1998 (millions) $ 235 2,885 1,238 223 4,581 2,021 829 6,385 4,823 3,764 825 $ 87 2,618 1,312 166 4,183 2,327 400 886 6,041 3,773 3,854 766 Totalassets .................................................................. � ............................................................... � LIABILITIES AND PARTNERS' CAPITAL Current liabilities Accounu payable ................... .... . $ 1,440 $ 1,473 .... .......................................................... .................................. articiparions and programming costs payable ........................................................................... 1,673 1,515 Debt due within one yeaz .................... 6 6 ........................................................................................ Other current liabiliries, including $821 and $370 million due to Time Wamer ........................ 2,075 1.942 Totalcurrent liabiliries ................................................................................................................ 5,194 4,936 Long-term debt ........................ . ... 6,?25 6,578 . . ..............• � . . ........... .............. .................. .......... .. Other long-term liabiliries, including $1.024 and $1.130 billion due to Time Warner ............... 3,166 3,267 Minority interests ......................................... 1,801 1,522 • . .......................... .......................... Prefeaed stock of subsidiary holding solely a mortgage note of its pazent ................................ Time Wamer General Parniers' Senior Capital ........................................................................... - 217 - 603 Partners' capitat Conuibutedcapital ........................................... ........................................... 7,338 7,341 ............................... Undistributed parmership deficit ................................................................................................ (996) 2 234) Totalpartners' capital .................................................................................................................. 6342 5.107 Total liabiliries and parmers' capital .................................................................................. � ......... 23.228 See accompanying notes. 48 TIME WARNER ENTERTAINMENT COMPANY, L.P. CONSOLIDATED STATEMENT OF OPERATIONS (Unaudited) T6ree Months Nine Months Ended Seotember 30. Ended Seotember 30. 1999 1998 1999 1998 (millions) Revenues (a) .....................................................................................� $3.474 3 220 $9.468 8 980 Costofrevenues(a)(b) ...................................................................... (2,362) (2,181) (6,266) (6,017) Selling, general and administrarive (a)(b) .......................................... (607) (577) (1,809) (1,761) Gain on sale or exchange of cable systems and invesunenu ............. 358 6 1,118 90 Gain on eazly tennination of video dis�iburion agreement ............... _ _ 215 = Business segment operating income .................................................. 863 468 2,726 1,292 Interest and other, net (a) ................................................................... (185) (203) (577) (550) Minority interest ................................................................................ (60) (52) (361) (198) Corporate services (a) ........................................................................ (1g) �18) �) �) Income before income taxes .............................................................. 600 Income taxes ...................................................................................... �) 3 Netincotne ........................................................................................ S 561 195 1,734 �23) �94) $ 172 � 490 �) 55 � (a) Includes the following income (expenses) resulting from �ansactions with the parmers of TWE and other related companies: Revenues .................................................................................................... $150 $227 $422 $474 Cost ofrevenues ..................................................................... (62) (49) . (198) (142) Selling, general and administrative ......................................... (7) (14) (23) (16) Gain on sale or exchange of cable systems and invest�nu... 308 - 308 - Interest and other, aet .............................................................. (8) 1 20 6 Corporate expenses ................................................................. (18) (18) (54) (54) (b) Includes depreciarion and amortization expense of : .................... � 356 � ��2$ �1. � See accompanying notes. 49 TIME WARNER ENTERTAINMENT COMPANY, L.P. CONSOLIDATED STATEMENT OF CASH FLOWS (Unaudited) OPERATIONS Netincome ................................................................................................................................. Adjustinents for noncash and nonoperating items: Depreciation and amortization .................................................................................................... Changes in operating assets and liabiliries .................................................................................. Cashprovided by operarions ....................:................................................................................ Nine Months Ended Seotember 30. 1999 1998 (millions) $1,640 $ 435 998 1,085 (433) (247) 2.205 1.273 INVESTING ACTMTIES Investmentsand acquisirions ...................................................................................................... (273) (335) Capitalexpenditures ................................................................................................................... (1,009) (1,092) Investmentproceeds ................................................................................................................... 342 540 Collection of loan to Time Warner ............................................................................................. 400 - Cash used by investing acrivities ................................................................................................ 540) 887) FINANCING ACTIVITIES Boaowings................................................................................................................................. 1,854 1,515 Debtrepaymenu......................................................................................................................... (1,893) (840) Redemprion of preferred stock of subsidiary .............................................................................. (217) - Capitaldisnibutions .................................................................................................................... (1,116) (1,060) Other........................................................................................................................................... 145) �g) Cashused by financing activiries ................................................................................................ 1 517) 583) INCREASE (DECREASE) IN CASH AND EQIJIVALENTS .............................................. CASH AND EQiJIVALENTS AT BEGINNING OF PERIOD ......................................:..... CASH AND EQiJIVALENTS AT END OF PERIOD ........................................................... See accompanying notes. 50 148 (197) 87 322 235 � TI'VIE WARNER ENTERTAINMEh'T COMPANY, L.P. CONSOLIDATED STATEMENT OF PARTNERSHIP CAPITAL (Unaudited) Nine Months Ended Se�rtember 30. 1999 ]998 (millions) BALANCE AT BEGINI�IING OF PERIOD ............................................................................ $5,107 Netincome ................................................................................................................................. 1,640 Other comprehensive income (loss) ........................................................................................... 6 Comprehensive income�>> ............................................................................................................ 1,646 Stock option and tax-related distributions .................................................................................. (383) Dis�ibution of Time Warner Telecom interests .......................................................................... - Allocarion of income to Time Warner General Partners' Senior Capital .................................... (24) Other........................................................................................................................................... _L) $6,333 435 �) 414 (746) (191) (52) _�) BALANCE AT END OF PERIOD .......................................................................................... � �5 7 4 (a) Comprehrnsive income for the thm months rnded September 30, 1999 and 1998 was $520 million and SI67 million, rcspecevely. See acco�anying notes. 51 TIME W,�RNER EN'TERTAINMENT COMPA.'�'Y, L.P. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Unaudited) 1. DESCRIPTTON OF BUSINESS AND BASIS OF PRESENTATION Description of Business Time Warner Entertainment Company, L.P., a Delaware limited par�ership ("TWE"), classifies its business interests into three fundamental areas: Cable Networkr, consisting principally of interests in cable television pro�mming; Filmed En[ertainmenr, consisting principally of interests in filmed entertainment, television production and television broadcastiag; and Cable, consisting principally of interests in cable television systems. Each of the business interests within Cable Networks, Filmed Entertainment and Cable is important to TWE's objecrive of increasing partner value through the crearion, extension and dis�ibution of reco, ;,able brands and copyrights throughout the world. Such brands and copyrights include (1) HBO and Cinemax, the leading pay television services, (2) the unique and extensive film, television and animarion libraries of Warner Bros. and �ademarks such as the Looney Tunes characters and Batman, (3) The WB Network, a national broadcasting network launched in 1995 as an extension of the Waraer Bros. brand and as an additional dis�ibution oudet for Warner Bros.' collection of childrea's cartoons and television programming, and (4) Time Warner Cable, currently the lazgest operator of cable television systems in the U.S. The operating results of TWE's various business segments aze presented herein as an indication of financial performance (Note 8). Except for start-up losses incurred in connecrion with The WB Network, TWE's principal business segments generate significant operating income and cash flow from opeiations. The cash flow &om operations generated by such business segments is considerably greater than their operating income due to significant amounts of noncash amortization of intangible asseu recogiized principally in Time Warner Cor�anies, Inc.'s ("Time Wamer") $14 billion acquisition of Wamer Communications Inc. ("WCI") in 1989 and $1.3 billion acquisition of the minority interest in American Television and Communications Corporation ("ATC") in 1992, a porcion of which cost was allocated to TWE upon the capitalization of the parmership. Noncash amortizarion of intangible assets recorded by TWE's business segments amounted to $130 million and $129 million for the three months ended September 30, 1999 and 1998, respecrively and $366 million and $387 million for the nine months ended September 30, 1999 and 1998, respectively. Time Warner aad certain of its wholly owned subsidiaries collecrively own general and limited parniership interests in TWE consisting of 74.49% of the pro rata priority capital ("Series A Capital") and residual equity capital ("Residual Capital"), and 100% of the junior priority capital ("Series B Capital"). The remaining 25.51% limited parmership interests in the Series A Capital and Residual Capital of TWE are held by a subsidiary of MediaOne Group, Inc. ("MediaOne"). Certain of Time Wazner's subsidiaries are the general parmers of TWE ("Time Warner General Parmers"). Basis of Presentation The accompanying consolidated financial statements aze unaudited but, in the opinion of management, contain all the adjustinents (consisring of those of a normal recurring nature) considered necessary to present fairly the financial posirion and the results of operarions and cash flows for the periods presented in conformity with generally accepted accounting principles applicable to interim periods. The accompanying consolidated financial statements should be read in conjunction with the audited consolidated financial statements of TWE included in its Annual Report on Form 10-K for the year ended December 31, 1998 (the "1998 Form 10-K"). 52 TIME WARNER ENTERTAINMENT COMPA1rY, L.P. NOTES TO CONSOLIDATED FINANCIAL STATEMETTS--(Continued) (Unaudited) Reclassifications Certain reclassifications have been made to the prior year's financial statements to conform to the 1999 presentation. 2. GAIN ON TERMINATION OF MGM VIDEO DISTRIBUTION AGREEMENT In Mazch 1999, Warner Bros. and Me�o-Goldwyn-Mayer, Inc. ("MGM") ternunated a long-term distriburion agreement under which Warner Bros. had exclusive worldwide distriburion rights for MGM/United Artists home video product. In connecrion with the eazly termination and settlement of this dis�ibution agreement, Wamer Bros. recognized a net pretax gain of approximately $215 million, which has been included in operating income in the accompanying consolidated statement of operarions. 3. GAIN ON SALE OR EXCIiANGE OF CABLE TELEVISION SYSTEMS AND INVESTMENTS In 1999 and 1998, lazgely in an effort to enhance iu geographic clustering of cable television properties, TWE sold or exchanged vazious cable televisioa systems and invesunenu. The 1999 transactions included a large exchange of cable television systems serving approximately 450,000 subscribers for other cable television systems of compazable size owned by TCI Conununications, Inc., a subsidiary of AT&T Corp., and a large exchange of cable television systems serving approximately 160,000 subscribers for other cable television systems of compazable size owned by MediaOne. As a result of these �ansactions, the operating results of TWE include net pretax gains for the third quarter of $358 million in 1999 and $6 million in 1998. Net pretax gains for the first nine �nths of the year amounted to $1.118 billion in 1999 and $90 million in 1998. 4. INVESTMENf IN PRIMESTAR TWE owns an approximate 24% equity interest in Primestar, Inc. ("Primestar"). In January 1999, Primestar, an indirect wholly owned subsidiary of Primestar and the stockholders of Primestar entered into an agreement to sell Primestar's medium-power direct broadcast satellite business and assets to D'uecTV, a competitor of Primestar owned by Hughes Electronics Cocp. In addition, a second agreement was entered into with DirecN, pursuant to which DirecTV agreed to purchase Primestar's rights with respect to the use or acquisirion of certain high-power satellites from a wholly owned subsidiary of one of the stockholders of Primestaz. In April 1999, Primestar closed on the sale of its medium- power direct broadcast satellite business to DirecTV. Then, in June 1999, Primestar completed the sale of iu high-power satellite rights to DirecT'V. As a result of those transactions, Primestar began to substaatially wind down its operations during the first quarter of 1999. TWE recognized its share of Pr�aestar's 19991osses under tbe equity method of accounting. Such losses are included in interest and other, net, in the accompanying consolidated statement of operations. As of September 30, 1999, Primestar has substantially completed the wind down of its operations. As such, funue wind-down losses are not expected to be material to TWE's operatiag resulis. 53 5. TIME WARr1ER ENTERTAINMENT COMPANY, L.P. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued) (Unaudited) INVENTORIES Inventories consist of: F111ri COStS: Released, less amortizarion ........................................................... Com�leted and not released ............................... ........................... In process and other ...................................................................... Library, less amortizarion ....................................... ...................... Programrning costs, less amortizarion ........................:. ..................... Merchandise ...................................................................................... Total.................................................................................................. 6• PREFERRED STOCK OF SUBSIDIARY Seotember 30. 1999 December 31. 1998 Current Noncurrent Current Noncurrent (millions) $ 609 164 36 331 98 � $ 735 $ 614 $ 744 b4 179 76 324 23 572 521 - 560 377 426 375 - 70 � � $2..� 7 In February 1997, a newly formed, substantially owned subsidiary of TWE (the "REIT") issued 250,000 shares of prefeaed stock ("REIT Prefeaed Stock"). The REIT was intended to qualify as a real estate investrnent tivst under the Internal Revenue Code of 1986, as amended. In Mazch 1999, the REIT redeemed all of its shazes of REIT Prefeaed Stock at an aggregate cost of $217 million, which approximated net book value. The redemprion was funded with borrowings under TWE's bank credit agreement. Pursuant to its terms, the RETT Preferred Stock was redeemed as a result of proposed changes to federal tax regulations that substantially increased the likelihood that dividends paid by the REIT or interest paid to the REIT under a mortgage note of TWE would not be fully deducrible for federal income tax purposes. 7. PARINERS' CAPITAL TWE is required to make dis�ibutions to reimburse the parniers for income taxes at statutory rates based on their allocable share of taxable income, and to reimburse Time Warner for stock options granted to employees of TWE based on the amount by which the market price of Time Wamer Inc. common stock exceeds the oprion exercise price on the exercise date or, with respect to options granted prior to the TWE capitalization on June 30, 1992, the greater of the exercise price or the $13.88 market price of Time Warner Inc. common stock at the time of the TWE capitalization. TWE accrues a stock oprion distribution and a coaesponding liability with respect to unexercised options when the market price of Time Warner Inc. common stock increases during the accounting period, and reverses previously accrued stock option distributions and the corresponding liability when the market price of Time Warner Inc. common stock declines. Duriag the nine months ended September 30, 1999, TWE accrued $316 millioa of tax-related disuibutions and $67 million of stock option dishibutions, based on closing prices of Time Warner Inc. common stock of $60.75 at September 30, 1999 and $62.06 at December 31, 1998. During the nine months ended September 30, 1998, TWE accrued $264 million of tax-related dis�ibutions and $482 million of stock option distributions as a result of an increase at that time in the market price of Time Warner Inc. common stock. Also, during the nine months ended September 30, 1998, Time Wazner Cable's business telephony operations were reorganized into a separate entity named Time Warner Telecom Inc. ("Time Warner Telecom"). In coffiection with that reorganization, TWE recorded a$191 million noncash distribution of its business telephony net assets to its partaers based on their historical cost. During the nine months ended September 30, 1999, TWE paid distiibutions to the Time Warner General Partaers in the amount of $489 million, consisting of $316 million of tax-related dis�iburions aad $1 ?3 million of stock option related distributions. During the nine months ended September 30, 1998, TWE paid the Time Wamer General Par�ers distributions in the amount of $1.060 billion, consisting of $264 million of tax-related dis�iburions, $217 million 54 TIME WARNER ENTERTAINMENT COMPANY, L.P. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--{Continued) (Unaudited) of stock oprion related disaiburions and a$579 million disuiburion to the Time Warner General Pazmers relating to their Senior Capital interests. In July 1999, TWE borrowed $627 million under iu bank credit agreement and paid a distriburion to the Time Warner General Parmers to redeem the remaining portion of their senior priority capital interests, including a prioriry capital return of $173 million. Time Wamer used a pordon of the proceeds received from this disuibuaon to repay all $400 million of outstanding borrowings under iu credit agreement with TWE. 8. SEGMENT INFORMATION TWE class�es its business interesu into three fundamental areas: Cable Networks, consisring principally of interests in cable television programaring; Filmed Entenainment, consisting principally of interesu in filmed entertainmen� television producuon and television broadcasting; and Cable, consisting principally of interesu in cable television systems. Informarion as to the operations of TWE in different business segmenu is set forth below based on the nature of the products and services offered. TWE evaluates performance based on several factors, of which the primary financial measure is business segment operating income before noncash amortization of intangible assets ("EBITA"). The operating resulu of TWE's cable segment reflect: (i) the �ansfer of Time Warner Cable's direct broadcast satellite opentions to Pr�i�star, a separate holding company, effective as of April 1, 1998, (ii) the forn�ation of the Road Runner joint venture to operate and expand Time Warner Cable's aad MediaOne's existing high-speed online businesses, effective as of June 30, 1998, (iii) the reorganization of Time Warner Cable's business telephony operations into a sepatate entity now natned Time Warner Telecom Inc., effecrive as of July 1, 1998 and (iv) the forn�arion of a joint venture in Texas that owns cable television systems serving approximately 1.1 million subscribers, effective as of December 31, 1998 (collectively, the "1998 Cable Transactions"). These transacrions are described more fully in TWE's 1998 Form 10-K. Three Mont6s Nine Moaths Ended Seotember 30. Ended Sentember 30. , 1999 1998 1999 1998 (millions) Revenues Filmed Entertainment-Warner Bros ................................................... $1,862 $1,727 $4,688 $4,364 Broadcasting-The WB Network ........................................................ 84 64 246 170 Cable Networks-HBO ........................................................................ 540 505 1,612 1,526 Cable ................................................................................................. 1,124 1,052 3,312 3,289 Intersegment elimination ................................................................... 1136) _(128) �� (369) Total.................................................................................................. 3_474 � ! � � 55 TIME WqRNER ENTERTAINMENT COMPAri'Y, L.P. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--{Continued) (Unaudited) Three Months Nine Months Ended Sentember 30. Ended Seotember 30. 1999 1998 1999 1998 EBITA�'� (millions) Filmed Entertainment-Wamer Bros.�Z� ............................................... $180 $161 $ 658 $ 401 Broadcasting-The WB Network ........................................................ (24) (17) (95) �7g� CableNetworks-HBO ........................................................................ 138 117 394 339 Cable�'� .............................................................................................. 699 336 2.135 1.017 Total.......................................................................................:.......... �.99� $52Z � � (1) EBITA represrnrs businas segmrnt opendng income before noncuh amorti�ation of intangible assets. After deducring amortizadon of intangible assets, TWE's bu�iness segrr�ent operadng income for the tivee and nine months ended September 30, 1999, respecevely, and for the corresponding periods in the prior year was $863 million and $2.�26 billion in 1999 and $468 million and 51.292 biilion in 1998. (2) Includes a net prctax gain of approximately $215 million reco�ized in the first quarrer of 1999 in conneceon with the early temiination and settlement of a long-temi home video distribudon ageement. (3) Includes net pretax gains reladng to the sale or exchangc of certain cable television systems of $358 million in the third qua�ter of 1999 and $6 million in the third quarter of 1998. Similarly, nine-month results include net pretax gains of $1.118 billion in 1999 and $90 million in 1998. Depreciation of Property, Plant and Equipment Filmed Entertainment-Waraer Bros ................................................... Broadcastiag-The WB Network ........................................................ CableNetworks-HBO ........................................................................ Cable................................................................................................. Total......... .................................................................................... Amortization of Intangible Assets �'� Filmed Entertainment-Warner Bros ................................................... Broadcastiag-The WB Network ........................................................ CableNetworks-HBO ........................................................................ Cable................................................................................................. Total.................................................................................................. Three Months Nine Months Ended Seotember 30. Ended Seotember 30. 1� 199g 1999 1998 (millions) $ 44 $ 48 - 1 7 6 175 174 � �222 $109 $126 1 1 20 16 502 555 � � Three Months Nine Months Ended Seotember 30. Ended Seotember 30. 1999 1998 1999 1998 (millions) $30 $33 1 - 99 96 � � $91 $99 3 2 272 286 �35� �.$Z (1) Arno�ti�ation includes am�Cradon relating p� all business wmbinauons accqmoed for by tix purchase method, mcluding Time Wamer's S14 billion acquisioon of WCI in 1989 and $13 billion acquisidon of the minoriry interest in ATC in 1992. 9. COMMITMENTS AND CONTINGENCIES TWE is subject to numerous legal proceedings. In management's opinion and considering established reserves, the resolution of these matters will aot have a material effect, individually and in the aggregate, on TWE's consolidated financial statemenu. 56 10. TII�IE WpRNER ENTERTAINMENT COMPANY, L.P. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—{Continued) (Unaudited) ADDITIONAL FINANCIAL INFORMATION Interestexpense .......................................................................................................................... Cash paymeats made for interest ................................................................................................ Cash payments made for income taxes, net ................................................................................ Noncash capital distributions ...................................................................................................... Nine Months Ended Seotember 30. 1999 1998 (millions) $411 $418 394 419 84 57 67 673 Noncash investing activities iacluded the exchange of certain cable television systems in 1999 and 1998 (see Note 3). Noncash iavesting activities in �e first nine months of 1998 also included the �ansfer of cable television systems (or interests therein) serving approximately 650,000 subscribers that were formerly owned by subsidiaries of Time Warner to the TWE-Advance/I�lewhouse Paronerstrip, subject to approximately $1 billion of debt, in exchange for common and preferred parUnership interests therein, as well as certain related �ansactions (collectively, the "TWE-t1/N Transfers"). For a more comprehensive descriprion of the TWE-A/N Transfers, see TWE's 1998 Form 10-K. 57 Part II. Other Information Item 1. Legal Proceedings. Reference is made to the various acrions filed against American Family Enterprises ("AFE"), a company engaged in magazine sweepstakes solicitations which is 50% owned by a subsidiary of'Time Inc., described on page I�2 of Time Waraer's Annual Report on Form 10-K for the year ended December 31, 1998 (the "1998 Form 10-K"). On October 29, 1999, AFE filed for banla�uptcy protecrion pursuant to Chapter 11 of the Banla�uptcy Code. In conjunction with the banla�uptcy filing, AFE has also announced a settlement in principle of the consolidated private actions presently pending against it in Federal court, the terms of which remain confidenrial. Private acrions pending against AFE in various State courts have been.stayed and Time Warner expects these acrions to be resolved by the operarion of the Federal court settlement and the banlQUptcy proceedings. Time Warner does not expect that the outcome of the banlauptcy proceedings and the costs of settlemeat of such actions will be material to its future operatiag results and financial condition. Reference is made to the consolidated actions referenced as In re Compact Disc Antim�st Litigation descnbed on pages I�0 and I� 1 of Time Wazner's 1998 Form 10-K. The Court has scheduled trial to coaanence on February 14, 2000. Plaintiffs claim substantial and treble damages against all record coa�any defendants. Reference is made to the lawsuit filed by former President of Indonesia H.M. Suharto against Time Inc. Asia described on page 64 of Time Warner's Quarterly Report on Form 10-Q for the quarter ended June 30, 1999. The Indonesian Court has denied a pre-�ial motion contesting jurisdiction. Further pre-�ial proceedings have been scheduled aad Time Inc. Asia expects that �ial will commence shortly thereafter. Reference is made to the litigation entided Parker, et al. v TWE, et al., described on page I-42 of Time Wazner's 1998 Form 10-K. The Court, on reconsideration of its earlier decision to grant defendants' motion to dismiss this acuon, as had been reported on page 50 of Titne Waraer's Quarterly Repot on Form 10-Q for the quarter ended March 31, 1999, has now denied that motion. Item 6. Eahibits and Reports on Form 8-K. (a) Exhibits. The exhibits listed on the accompanyiag Exhibit Index are filed or incorporated by reference as a part of this report aad such Exhibit Index is incorporated herein by reference. (b) Reports on Form 8-K. (i) Time Waraer filed a C�urent Report on Form 8-K dated July 12, 1999 in which it reported in Item 5 that Time Warner had entered into an agreement with CDNOW, Inc. and Sony Corporarion of America to combine the businesses of CDNOW and Columbia House. (ii) Time Waraer filed a C�rrent Report on Form 8-K dated August 3, 1999 reporting in Item 5 Time Warner's consolidation, for accounting piuposes, of the Entertainment Group (which substantially consists of TWE) retroactive to the beginning of 1999. 58 TIM� WARNER INC. SIGNATURE Pursuant to the requirements of the Securiries Exchange Act of 1934, the regis�ant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized. TIME WARNER INC. (Registrant) By: /s/ Joseph A. Ripp Name: Joseph A. Ripp Title: Executive Vice President and Chief Financial Officer Dated: November 12, 1999 EXHIBIT INDEX Pursuant to Item 601 of Regulations S-K Ezhibit No. Description of Eahibit 2�-1 Financial Data Schedule with respect to the period ending September 30, 1999. 2�•2 Restated Financial Data Schedule with respect to the period ending March 31, 1999. 23.3 Restated Financial Data Schedule with respect to the period ending June 30, 1999. SECURITIES AND EXCHANGE COMMISSION Washington, D.C. 20549 FORM 10-K ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the Sscal year ended December 31, 1998. Commission file number 1-12259 TIME WARNER INC. (Exact name of registrant as speciSed in its charter) Delaware (State or other jurisdiction of inrnrporatioa or orgaeizatioo) 75 Rockefeller Plaza, New York, N.Y. (Address of priocipal executive o�ces) 13-3527249 (I.R.S. Employer Identi6cation No.) 10019 (Zip Code) RegistranNs telephone number, including area code: (212) 484-8000 Securities registered pursuant to Section 12(b) of the Act: Title of each ciass Name oi each exchange on which registered Common Stock, $.Ol par value New York Stock Exchange Rights to Purchase Series A Participating Cumulative Preferred Stock New York Stock Exchange Securities registered pursuant to Section 12(g) of the Act: None 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 � No ❑ Indicate by check mazk 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. ❑ As of March 15, 1999, there were 1,133,899,660 shares of registrant's Common Stock and 57,061,942 shares of registrant's Series LMCN-V Common Stock outstanding. The aggregate market value of the registrant's voting securities held by non-afiiliates of the registrant (based upon the closing price of such shazes on the New York Stock Exchange Composite Tape on March I5, 1999) was approximately $70.65 billion. DOCUMENTS INCORPORATED BY REFERENCE: Descriptioo of documeot Part of the Form 10-K Portions of the Definitive Prox� Statement to be Part III (Item 10 through Item 13) used in connection with the registrant's 1999 Annual Meeting of Stockholders. � W � � � � W �u I� � � U ��-. NH Q w 3Z �� H o U � z F � � Q � W � � [7� � z �" C�i � H � . � � F Z � o �a m m '; � � : .:a a -- � � � �; y� � ��y, �.�. N C a C '; a 0 0 3 �a Q � �,�� ,; Q � � F .� n H v � -.; � . O 0 U _ � v z s° y _ �.� m �.�. a a a z � � z � � 3U F z � z E� ¢ � [2] z W F m O i � ,°�, z � '' s z w � s Z3 w Y O �o z °' �, x < U � Z a � ¢ 3 < g U H a z- � � � � �v o U � � � y � - p� ." � "' g? E" a � � � \ � '. LL7 N U � Z O a s � � � ¢ � [,�t7 Z -�] F wf w: � � Y � � U E3-' [J] z 0 `o .^ � `o .� d = .n T O 6 = 0 0 � 0 c C a v � U � E - 3� � � F o t � • u O �T � 6 `. U v t ds =� .T -z° v� Av � � � � - - 'a 'a T T �o �`o d 6 � 00 a c. � .a L t o. e a 0 0 T O c .� U F 0 A .y .� °E 0 d � O e PART 1 Item 1. Business Time Wamer Inc. (the "Company"); together with its consolidated and unconsolidated subsidiaries, is the world's leading media and entertainment company. The Company classifies its business interests into four fundamental areas: • Cable Networks, consisting principally of interests in cable television programming; • Publishing, consisting principally of interests in magazine publishing, book publishing and direct marketing; • Entertainment, consisting principally of interests in filmed entertainment, television production, television broadcasting, recorded music and music publishing; and • Cable, consisting principally of interests in cable television systems. The Company is a holding company that derives its operating income and cash flow from its investments in its subsidiaries. In October 1996, the Company completed the merger of Tumer Broadcasting System, Inc. ("TBS") thereby acquiring the remaining approximately 80% interest in TBS that the Company did not already own (the "TBS Transaction"). As a result of the TBS Transaction, a new parent company with the name "Time Warner Inc." replaced the old parent company of tbe same name and the old parent company, which changed its name to Time Warner Companies, Inc. ("1"WCI"), and TBS became separate, wholly owned subsidiaries of the new parent company. Information on the TBS Transaction is set forth in Note 3, "TBS Transaction," to the Company's consolidated financial statements, at pages F-38 and F-39 herein. The assets of TWCI consist primarily of investments in its consolidated and unconsolidated subsidiaries, including Time Warner En- tertainment Company, L.P. ("TWE"). For convenience, the terms the "Registrant," "Company" and "Time Warner" are used in this report to refer to both the old and new parent company and collectively to the parent company and the subsidiaries through which its various businesses are conducted, unless the context otherwise requires. TWE TWE is a Delaware limited partnership that was formed in 1992 to own and opera�e substantially all of the business of Warner Bros., Home Box Office and the cable television businesses owned and operated by the Company prior to such date. Currently, the Company, through its wholly owned subsidiaries, owns general and limited partnership interests in 74.49°70 of the pro rata priority capital ("Series A Capital") and residual equity capital ("Residual Capital") of TWE and 100% of the senior priority capital and junior priority capital of TWE. The remaining 25.51°l0 limited parUnership interests in the Series A Capital and Residual Capital of TWE are held by a subsidiary of MediaOne Group, Inc. ("MediaOne"). The Company does not consolidate TWE and certain related companies (the "Entertainment Group") for financial reporting purposes. Two Time Wamer subsidiaries are the general partners of TWE. See also "Description of Certain Provisions of the TWE Partnership Agreement" for additional information about the organization of TWE. In 1995, 1"WE formed a cable television joint venture with the Advance/Newhouse Partnership ("Advance/Newhouse") known as TWE-A/N. As of December 31, 1998, TWE-A/N owned cable television systems (or interests) serving 63 million subscribers. TWE is the managing partner of TWE-A/N, which is owned 64.8% by TWE, 33.3°16 by Advance/Newhouse and 1.9% by TWI Cable Inc. For information about certain transactions affecting TWE-A/N during 1998, see Note 2, "Cable Transactions," to the Company's consolidated financial statements on pages F-35 through F-38 herein. Recent Events On February 1, 1999, the Company announced that it intended to form a joint venture with AT&T Corp. ("AT&T') pursuant to which the joint venture will have the right for up to a 20-year term to offer AT&T- I-1 branded cable telephone service to residential and small business customers over Time Warner Cable's existing cable network. Under the preliminary terms announced by the parties, the joint venture will be 77.5% owned by AT&T and 22.5% owned by TWE, TWE-A/N and TWI Cable, Inc., collectively. The joint venture is expected to make payments to Time Warner Cable initially based on the number of homes included in the cable network that have been upgraded to fiber optic capacity and will pay a monthly fee during the term per telephony subscriber, subject to guaranteed minimums, and is expected to make future revenue sharing payments if the joint venture surpasses targeted monthly subscriber revenue levels. The joint venture is also expected to purchase telephony equipment and fund Time Warner Cable's expenses of installing and maintaining such equipment. It is expected that AT&T will fund all of the joint venture's negative cash flow. See also "Management's Discussion and Analysis of Results of Operations and Financial Condition — Cable Strategy" at pages F-16 through F-18 herein. The joint venture is subject to the negotiation and execution of definitive agreements, approval of the final terms by MediaOne and Advance/Newhouse and certain regulatory and other approvals. No assurances can be given that such agreements and approvals will be completed or obtained. Caution Concerning Forward-Looking Statements 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 cunent expectations and are naturally 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. More detailed information about those factors is set forth on pages F-22 and F-23 of "Management's Discussion and Analysis of Results of Operations and Financial Condition." Time Warner is under no obligation to (and expressly disclaims any such obligation to) update or alter its forward-looking statements whether as a result of new information, future events or otherwise. I-2 CABLE NETWORKS The Company's Cable Networks business consists principally of domestic and international basic cable networks and pay television programming services and the operation of World Championship Wrestling and sports franchises. TBS's networks (collectively, the "Turner Networks") constitute the principal component of the Company's basic cable networks: Cable News Network ("CNN"), CNN International, Headline News, CNN Financial News Network ("CNNfn"), TBS Superstation, Turner Network Television ("TNT'), Turner Classic Movies, Cartoon Network, CNN/Sports Illustrated and CNN en Espanol, all operated by TBS, which is wholly owned by the Company. TBS also operates several large advertiser- supported online sites, including the CNN family of Internet sites. Pay television programming consists of the multichannel HBO and Cinemax pay television programming services (collectively, the "Home Box Office Services"), operated by the Home Box Office division of TWE ("Home Box Office"). General The Company, through TBS, is the leading supplier of programming for the basic cable industry in the United States. The Turner Networks provide a wide variety of movies, sports, general entertainment, all-news and all-sports news programming. Through TWE's Home Box Office division, the Company distributes HBO, the leading domestic pay-TV service, as well as Cinemax. HBO and Cinemax offer uncut, commercial-free motion pictures and high-quality documentaries. In addition, HBO offers sporting and special entertainment events (such as concerts and comedy shows), and feature motion pictures, mini-series and television series produced specifically by or for HBO. The Turner Networks and the Home Box Otiice Services (collectively, the "Networks") distribute their programming via cable and other distribution technologies, including satellite distribution. A separate distribution subsidiary handles the sales and marketing of all of TBS's domestic basic cable networks to cable, satellite master antenna television ("SMATV") and multichannel MDS ("MMDS") systems and direct-to- home satellite ("DTH") distribution companies in the United States. The Networks generally enter into separate multi-year agreements, known as affiliarion agreements, with operators of cable television systems, SMATV, MMDS and DTH distribution companies that have agreed to carry such Networks. With the proliferation of new cable networks and services, competition for cable carriage on the limited available channel capacity has intensified. The programming produced for the Company's Networks is generally transmitted via C-band or Ku-band communications satellites from an uplinldng terminus and received on receivers located at local operations centers for each afiiliated cable company, or on home satellite dish receivers. Individual dish owners wishing to receive programming from one of the satellite distribution companies must purchase a consumer decoder from a local source and amange for its activarion. The Turner Networks (other than Turner Classic Movies, which is commercial free) generate their revenue principally from the sale of advertising time and from receipt of monthly per subscriber fees paid by cable system operators, DTH distribution companies, hotels and other customers (lrnown as affiliates) that have contracted to receive and distribute such networks. The Home Box Office Services and Turner Classic Movies, being commercial free, generate their revenue principally from the monthly fees paid by affiliates, which are generally charged on a per subscriber basis. Individual subscribers to the Home Box Office Services are generally billed monthly by their local cable company or DTH packager for each service purchased and are free to cancel a service at any time. As a result of acquisitions and mergers in the cable television industry in recent years, the percentage of the Networks' revenue from affiliates that are large DTH distribution companies or multiple system cable operators, such as Tele-Communications, Inc., a subsidiary of AT&T ("TCI") or Time Warner Cable, has increased. The Networks attempt to assure continuity in their relationships with affiliates and have entered into multi-year contracts with affiliates, whenever possible. Although TBS and Home Box Office believe the 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. I-3 Advertising revenue on basic cable networks is a function of the number of advertising spots sold, the "CPM," which is the average cost per thousand homes charged for such advertising, and market conditions. The CPM applicable to each network program varies depending upon its ratings (which measure the numbers of viewers delivered), the type of program and its time slot, which latter factors influence the demographics of such viewers, which are important to an advertiser. To evaluate the level of its viewing audiences, TBS utilizes the metered method of audience measurement as provided by A.C. Nielsen. Cable networks which have not achieved widespread cable system distribution are not able to achieve significant viewing levels and, as a result; do not command a high CPM for their advertising time. Turner Networks Domestic Networks Effective at year-end 1997, TBS Superstation converted to a copyright-paid cable network from an independent UHF television station whose signal was retransmitted by a third party common carrier via satellite. The network, while still transmitted over-the-air in the Atlanta market, is now retransmitted by TBS and delivered via satellite to cable systems in all 50 states, Fuerto Rico and the Virgin Islands, and has approximately 76 million subscribers. Its programming includes movies, sports, original productions and classic television comedies. As a broadcast television station, TBS Superstation relied principally on advertising revenue and received no dire�t compensation for its signal from cable systems. As a cable network, TBS Superstation also receives subscription revenue directly from cable and other distribution systems that carry the service. Other entertainment networks produced and distributed by TBS are TNT, which as of December 31, 1998 had approximately 75 million subscribers in the United States; Cartoon Network, with approximately 55 million subscribers in the United States; and Turner Classic Movies, a 24-hour, commercial-free network which presents classic films from TBS's MGM, RKO and pre-1950 Warner Bros. film libraries and which has approximately 31 million subscribers. Programming for these entertainment networks is derived; in part, from the Company's film, made-for-television and animation libraries as to which TBS or other divisions of the Company own the copyrights, licensed programming, including sports, and original productions. In February, TBS announced that it will launch a new regional entertainment network, Tumer South, in the fall of 1999. Targeting the Southeast, Tumer South will feature movies and sitcoms from the Turner library and original regional programming such as performance shows, regional news and sports. TBS has acquired programming rights from the National Basketball Association (the "NBA") to televise a certain number of regular season and playoff games on TBS Superstation and TNT through the 2001-02 season for which it has agreed to pay fees plus a share of the advertising revenues generated in excess of specified amounts. TBS Superstation also televises a certain number of baseball games of the Atlanta Braves, a major league baseball club owned by a subsidiary of TBS, for which rights fee payments are paid to Major League Baseball's central fund for distribution to all Major League Baseball clubs. CNN is a 24-hour per day cable television news service which has more than 75 million subscribers. Together with CNN Intemational, which is distributed outside the United States, CNN reaches more than 200 million homes in 212 countries and territories as of December 31, 1998. In addition to Headline News, which provides updated half-hour newscasts throughout each day, CNN has expanded its brand franchise to include CNNfn, launched in December 1995, featuring business and consumer news; and CNN/Sports Illustrated, a venture with Sports Illustrated, a Time Warner publication, which was launched in December 1996, featuring sports news and features. The Company has also expanded into a number of special market networks. CNN owns and operates 34 permanent news bureaus, of which ten aze in the United States and 24 are located around the world. In addition, a network of satellite newsgathering trucks, portable satellite uplinks and a network of approximately 600 domestic and 200 international broadcast television affiliates on six continents permit CNN to report live from virtually anywhere in the world. These affiliate arrangements, from I-4 which CNN obtains substantial news coverage, aze generally pursuant to contracts having terms of one or more years. Internationa[ Networks CNN Intemational ("CNNI") is a television news service which is distributed to multiple distribution platforms for delivery to cable systems, broadcasters, hotels and other viewers around the world on a network of 16 regional satellites. In 1997, TBS launched CNN en Espanol, a Spanish language all-news network in Latin America which, as of December 31, 1998, had 7.6 million subscribers. Each of CNNI and CNN en Espanol derives its revenues primarily from fees charged to cable operators, fees paid by other recipients of the CN1VI and CNN en Espanol signals, including hotels and over-fhe-air television stations, and the sale of advertising time. TBS also distributes region specific versions of TNT and Cartoon Network, on either a single channel basis or a combined channel basis, in approximately 120 countries in Latin America and the Caribbean, Europe, the Middle East, Africa and Asia. Each such network features all or a portion of its schedule in more than one language through dubbing or subtitling. Revenues from these services are derived both from subscription fees and advertising sales. CNN+, a Spanish language 24hour news network, was launched for distribution in Spain and Andorra on January 27, 1999. This new network is a 50/50 joint venture between TBS and Sogecable, S.A., an afiiliate of Canal Plus. CNN+ will derive revenues from cable and satellite subscription fees and advertising sales. Cartoon Network Japan, a Japanese-language, all animarion (including a significant amount of locally sourced, Japanese product) 24hour network, was launched in Japan in 1997. Cartoon Network Japan is a joint venture owned 4096 by TBS, 40% by ITOCHLJ and 2096 by Time Warner Entertainment Japan Inc. ("T'WE Japan"), which is 37.596 owned by Time Warner. Revenue sources for this network include both subscription and advertising sales. n-tv, a German language news network currently reaching neazly 40 million homes in Germany and contiguous countries in Europe, primarily via cable systems and satellite, is 49.8%-owned, in the aggregate, by TBS and a division of TWE and managed by TBS. n-tv relies principally on advertising revenues and receives no compensation for its signal from cable systems. TBS also manages the Company's interest in music video channels in Germany, Hungary and Asia. Internet Sites In addition to its cable networks, TBS operates various advertiser-supported Intemet sites. CNN News Group operates mulriple sites, primarily through CNN Interactive. CNN Interactive operates CNN.com as its general news service and online companion to CNN and six additional web sites, including AIIPolitics.com, a U.S. political newssite produced in conjuncrion with TIME magazine and Congressional Quarterly; CNN CustomNews, a personalized news site operated by Oracle technology; and additional online services in Spanish, Portuguese, Swedish and Norwegian. T'he CNN News Group also produces two other major news sites: CNNfn.com, a unit of CNN Financial News, and CNNSI.com, a sports site developed jointly with Sports Illustrated. The CNN News Group sites received 4.4 billion page impressions during 1998, more than double the aggregate traffic of the CNN News Group sites during 1997. In addition to producing content for the Internet, CNN Interactive produces and distributes CNN digital content for different platforms and technologies, including pagers, push technology, European teletext and certain mobile telephone technologies. In the entertainment field, as of November 1998, TBS's advertiser-supported CartoonNetwork.com was ranked by Media Metrix (based on audience composition) as one of the top three information and entertainment sites for children ages two to eleven. I-5 Home Box Office HBO, operated by the Home Box Office division of TWE, is the nation's most widely distributed pay television service, which together with its sister service, Cinemax, had approximately 34.6 million subscrip- tions as of December 31, 1998. Both HBO and Cinemax are available in multichannel format. ProgrammiRg A majority of HBO's programming and a large portion of that on Cinemax consists of recently released, uncut and uncensored theatrical motion pictures. Home Box Oflice's practice has been to negotiate licensing agreements of varying duration for such programming with major motion picture studios and independent producers and distributors. 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 a negotiated fee, which may be a function of, among other things, HBO and Cinemax subscription levels and the films' box office performances. Home Box Office attempts to ensure access to future movies in a number of ways. In addition to its exhibition of movies distributed by Warner Bros. and its regular licensing agreements with numerous distributors, it has agreements with DreamWorks SKG, Regency Entertainment, Sony Pictures Entertain- ment, Inc. ("Sony Pictures"), and Twentieth Century Fox Film Corporation ("Fox") pursuant to which the Home Box Office Services have acquired exclusive and non-exclusive rights to exhibit all or a substantial portion of the films produced, acquired and/or released by these entities during the term of each agreement. Home Box Of�ce has also entered into non-exclusive license agreements with Fox, Paramount Pictures Corporation, Sony Pictures and Walt Disney Pictures for older, library films. HBO also defines itself by the exhibition of contemporary and sometimes controversial pay television original movies and mini-series, sporting events such as boxing matches and Wimbledon, sports documenta- ries and the sports news program "Real Sports," dramatic and comedy specials and series, concert events, family programming, and documentaries that aze produced by independent production companies for initial exhibition on HBO. Other Interests Time Warner Sports, a division of Home Box Office, operates TVKO Pay-Per-View from HBO, an entity that distributes pay-per-view prize fights and other pay-per-view programming. In 1998, Home Box Office's own production company, HBO Independent Productions, produced "Everybody Loves Raymond," in its third season on CBS. Divisions of Home Box Office also produce comedy programming for HBO, Comedy Central, broadcast networks and syndication. Home Box Office is also co- owner of a U.K. television production company and of a separate joint venture for the international distribution of programming. When it controls the rights, Home Box Office also distributes theatrical films and made-for-pay television programming to other cable television or pay-per-view services and for home video and distributes its original programming into domestic syndication and abroad for television and home video viewing. International � HBO Ole, a 33.46%-owned partnership comprised of TWE (acting through its Home Box Office and Warner Bros. divisions), a Venezuelan company and two other motion picture companies, operates two Spanish-language pay television motion picture services, HBO Ole and Cinemax, which are currently distributed in Central and South America, Mexico and the Caribbean. TWE also has interests in several advertiser-supported television services distributed by HBO Ole in Latin America. HBO Brasil, another partnership in which TWE has an interest, distributes Portuguese-language pay television movie services in Brazil. 1"WE also has a 40% interest in HBO Asia, a movie-based pay television service which, together with Cinemax, is distributed to various countries in Southeast Asia. I-6 In addition to the Larin American and Asian ventures, Home Box Office has interests in pay television services in Hungary, the Czech Republic, the Slovak Republic, Poland and Romania. Other Basic Cable Network Interests The Company, through TWE, holds a 50% interest in Comedy Central, an advertiser-supported basic cable television service, which provides comedy programming. Comedy Central was available in approxi- mately 56 million homes at year-end 1998. The Company, through TWE, also holds a 50% interest in Court TV, which was available in approximately 32 million homes at year-end 1998. Court TV is an advertiser-supported basic cable television service providing coverage of live and taped legal proceedings during the day and a mix of fictional and real crime stories in the evening. Competition The Networks all face strong competition. Each of the Networks competes with other television programming services for distriburion on the limited number of channels available on cable and other television systems. All of the Networks compete for viewers' attention 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 services, online activities and other forms of news, information and entertainment. In addition, the Networks face competition for programming product with those same commercial television networks, independent stations, and pay and basic cable television services, some of which have exclusive contracts with modon picture studios and independent motion picture distributors. The Turner Networks and TBS's Intemet sites compete for advertising with numerous direct competitors and other media, as well. . The 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. Ot6er Cable Network Assets World Championship Wrestliag Through World Championship Wrestling ("WCW"), TBS produces wrestling programming for TBS Superstation and TNT, the domesric syndication markets and pay-per-view television. In addition to television programming, WCW is involved in ancillary businesses such as licensing and merchandising from which it derives revenues worldwide. Sports Franchises Through wholly owned subsidiaries, TBS owns the Adanta Braves major league baseball club and the Atlanta Hawks basketball team and has been conditionally granted a National Hockey League expansion franchise team to be known as the Atlanta Thrashers that will begin play in the 1999-2000 hockey season. TBS must meet certain sales and other objectives applicable to all other hockey expansion teams prior to a formal grant of right to operate the hockey team. Each national sports team is subject to the rules and regulations of the league to which it belongs. The teams derive income from gate receipts, advertising and related sales, suite sales, local sponsorships and local media, and share pro rata in proceeds from national media contracts and licensing activities of the relevant league, as well as expansion fees. A new, state-of-the-art arena adjacent to CNN Center is under construction and will be the future home of the Hawks and the Thrashers. The arena is being developed by a TBS subsidiary and the cost of the arena is being funded primarily with the proceeds from bonds issued by the City of Atlanta-Fulton County Recreation Authority. I-7 PUBLISHING The Company's Publishing business is conducted primarily by Time Inc., a wholly owned subsidiary of the Company, either directly or through its subsidiaries. Time Inc. is one of the world's leading magazine and book publishers and is one of the largest direct mail marketers in the world. Magazines General Time Inc. publishes some of the world's best-known magazines, including TIME, PEOPLE, SPORTS ILLUSTRATED, FORTUNE, MONEY, ENTERTAINMENT WEEKLY and InSTYLE. These magazines are generally aimed at a broad consumer market. They cover a broad range of topics of interest to potential readers, including current events, prominent personalities, sports, entertainment, business and personal finance, and lifesryle. Each magazine published by Time Inc. has an editorial staff under the general supervision of a managing editor and a business staff under the management of a president or publisher. Many of the magazines have numerous regional and demographic editions which contain the same basic editorial material but permit advertisers to direct their advertising to specific markets. Through the use of selective binding and ink-jet technology, magazines can create special custom editions targeted towards specific groups of readers. Magazine production and distribution activities are generally managed by centralized staffs of Time Inc. Fulfillment activities for Time Inc.'s magazines are generally administered from a centralized facility in Tampa, Florida. Some of the development properties and overseas operations employ independent fulfillment services and make their own amangements for production and distribution. Time Inc. has expanded its core magazine businesses through the developrnent of product extensions. These are generally managed by the individual magazines and involve specialized editions aimed at particular readership groups, publication of editorial content developed by the magazine staffs through different media, such as the Internet, hardcover books and television, and use of the brand name and reach of the core publications to expand into related products, such as merchandise. In June 1998, CNN and Time Inc. launched CNN Newstand, a collaborarion between CNN and TIME, FORTUNE and ENTERTAINMENT WEEKLY which airs four nights a week on CNN. Description oj Magazines The Company's magazines and their areas of interest are summarized below: TIME, which celebrated its 75th anniversary in 1998, summarizes the news and brings original interpretation and insight to the week's events, both national and international, and across the spectrum of politics, business, entertainment, sports, societal trends; health, and other areas of general consumer interest. TIME has also developed additional publications aimed at particular reader segments such as TIME FOR KIDS, an in-school weekly news magazine, and TIME DIGITAL, a supplement to TIME which covers technology-related issues. TIME also has five weekly English-language editions which circulate outside the United States: TIME Asia, TIME Atlantic, TIME Canada, TIME Latin America, and TIME South Pacific. SPORTS ILLUSTRATED is a weekly news magazine that covers virtually all forms of recreational and competitive sports. In addition, SPORTS ILLUSTRATED has developed SPORTS ILLUSTRATED FOR KIDS, a monthly sports-oriented magazine geared to children, and a special edition, GOLF PLUS. New venues for its editorial content have also been developed, including CNN/Sports Illustrated, a sports news cable television network and web site that is operated as a joint venture between SPORTS ILLUSTRATED and CNN. PEOPLE is a weekly magazine which reports on celebrities and other notable personalities in the fields of politics, sports and entertainment, or who otherwise come to prominent public attention due to acts of heroism, tragedy or other aspects of general human interest. PEOPLE has recently developed two PEOPLE I-8 offspring: PEOPLE en Espanol, a Spanish-language edition aimed primarily at Hispanic readers in the United States launched in 1997, and TEEN PEOPLE, aimed at teenage readers, launched in 1998. WHO WEEKLY is an Australian version of PEOPLE. Time Inc. has other magazines also directed at readers' interests in celebrities and entertainers. InST'YLE is a monthly magazine which focuses on celebrity lifestyles and includes reports and advice on beauty and fashion. ENTERTAINMENT WEEKLY is a weekly magazine which includes reviews and reports on television, movies, video, music, books, and multimedia and also offers entertainment-related merchandise directly to consumers. FORTUNE is a bi-weekly magazine which reports on worldwide economic and business developments. FORTUNE also provides extensive coverage of the activities of major or noteworthy corporations and business personalities, and compiles the annual FORTUNE SOO list of the largest U.S. corporations. MONEY is a monthly magazine which reports primarily on personal finance and provides information on �topics such as investing, planning for retirement and financing children's college educations. Time Inc. also publishes YOUR COMPANY, a bi-monthly magazine focusing on success stories, growth advice and operational issues for small businesses, and in 1998 acquired MUTUAL FLTNDS, a monthly magazine featuring extensive reports on mutual funds, including stories about retirement and college planning. LIFE is a monthly magazine which features photographic essays of important news events, prominent personalities and meaningful vignettes of the lives of ordinary people. LIFE also publishes hardcover books that include contemporary and historical photographs of note from its extensive collection. Time Inc. also publishes several regional magazines including SOUTHERN LIVING, a monthly regional home, garden, food and travel magazine focused on the South, published by Southem Progress Corporation ("Southem Progress"), and SUNSET, The Magazine of Western Living, a monthly focused on westem lifestyles published by Sunset Publishing Corporation ("Sunset Publishing"). COOKING LIGH'I' is published ten times a yeaz and promotes health and fitness through active lifestyles and good nutrition. Southern Progress also publishes SOUTHERN ACCENTS, a bi-monthly magazine that features architec- ture, fine homes and gardens, arts and travel, COASTAL LIVING, a bi-monthly magazine for people who "love the coast," PROGRESSIVE FARMER, a monthly regional fanning magazine and WEIGHT WATCHERS, a magazine published nine times a year under a license from Weight Watchers International, Inc. Time Publishing Ventures, Inc. ("TPV") manages Time Inc.'s specialty publishing titles. Pazents and families are addressed by PARENTING and BABY TALK, both of which are published ten times a year. In 1998, TPV acquired First Moments, Inc., a sampling company that targets newlyweds and new mothers. HEALTH is a women's consumer magazine about health and fitness published eight times in 1998 and HIPPOCRATES is a monthly trade magazine targeted at primary care physicians. TPV also publishes THIS OLD HOUSE magazine ten times a year pursuant to a licensing arrangement with public television station WGBH in Boston based on the popular home renovation television series. Time Inc.'s international operations include both regional versions of some of its core magazines, including TIME, PEOPLE and FORTUNE, as well as publications whose editorial content and focus are outside the United States. Such magazines include WALLPAPER, PRESIDENT, DANCYU, and ASIAWEEK. Time Inc. also has management responsibility for most of the American Express Publishing Corpora- tion's operations, including its core lifestyle magazines TRAVEL & LEISURE and FOOD & WINE, as well as DEPARTURES magazine, which is a controlled circulation magazine distributed to holders of the Platinum Card issued by American Express. In 1998, American Express Publishing launched TRAVEL & LEISURE GOLF inagazine. Time Inc. receives a fee for managing these properties. Time Inc. Custom Publishing is a marketing division of Time Inc. producing magazines and newsletters for corporate clients utilizing content from Time Inc. magazines and archival photography from the Time Inc. photography collecrion, as well as original content. I-9 Circulation Time Inc.'s magazines are sold primarily by subscription and delivered to subscribers through the mail. Subscriptions are sold by direct mail and online solicitation, subscription sales agencies, television and telephone solicitation and insert cards in Time Inc. magazines and other pnblications. Single copies of magazines are sold through retail news dealers and other consumer magazine retailers, such as supermarkets, drug stores, and discount stores, which are supplied by wholesalers or directly from a Time Inc. subsidiary. Circulation drives the advertising rate base, which is the guaranteed minimum paid circulation level on which advertising rates are based. The Time Inc. titles with the 10 highest rate bases on December 31, 1998 were: Title TIME........................................ ................. PEOPLE......................................................... SPORTS ILLUSTRATED . . . . . . . . . . . .. . . . . . . . . . . . . . . . . . . . . . . .. . . . . SOUTHERN LIVING . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . MONEY......................................................... LIFE............................................................ SUNSET............................................... ...... COOKING LIGHT ............................................... ENTERTAINMENT WEEKLY . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .. . .. . Rate Base 4,000,000 3,250,000 3,150,000 2,450,000 1,900,000 1,500,000 1,425,000 1,350,000 1,350,000 PARENTING .................................................... 1,350,000 Time Distribution Services Inc. ("TDS") is a national distribution company responsible for the retail sales, distribution, marketing and merchandising of single copies of periodicals .for Time Inc. and other publishers. TDS distributes periodicals either through a magazine wholesaler network which services retail outlets such as newsstands, supermarkets, convenience and drug stores or in some cases directly to retailers. Warner Publisher Services Inc. ("WPS") is a major distributor of magazines and paperback books sold through wholesalers in the United States and Canada. WPS is the sole national distributor for MAD magazine, the publications of DC Comics, and certain publications and paperback books published by other publishers, including Conde Nast, Petersen and Ziff-Davis. Advertisiag Advertising carried in Time Inc. magazines is predominantly consumer advertising. In 1998, Time Inc. magazines accounted for 21% of the total advertising revenue in consumer magazines, as measured by the Publishers Information Bureau ("PIB"), which measures advertising placed in consumer magazines. Time Inc. had the three leading magazines in terms of advertising dollars and seven of the top 25: Title PEOPLE..........................................:............... TIME............................................................ SPORTS ILLUSTRATED . . . . . . . . . . . . .. . . . . . . . . . . . . . . .. . . . . . . . .. . FORTUNE ........................................................ ENTERTAINMENT WEEKLY .. . . . .. .. ... . .. . . . . . . .. . . .. . . .. .. . .. . MONEY.......................................................... SOUTHERN LIVING .............................................. PIB Rank 10 18 21 25 The five leading categories of advertising carried in Time Inc. magazines in 1998, according to PIB were, in descending order, domestic automobile manufacturers, toiletries and cosmetics, food, computers and financial. Time Inc. places local advertising for local and national advertisers ihrough its subsidiary, Media Networks, Inc. ("MNI"). MNI partners with some of the country's leading national magazines, including I-10 several Time Inc. magazines, to offer local mazketers the opportunity to advertise to select targeted areas defined by sectional postal centers. Paper and Printing Lightweight coated paper constitutes a significant component of physical costs in the production of magazines. Time Inc. has contractual commitments to ensure an adequate supply of paper, but periodic shortages may occur in the eveht of strikes or other unexpected disruptions in the paper industry. During 1998, Time Inc. purchased paper principally from six independent manufacturers, with the larger relationships under contracts that, for the most part, are either fixed-term or open-ended at prices determined on a market price or formula price basis. Printing and binding for Time Inc. magazines are accomplished primarily by major domestic and intemational independent printing concems in approximately 20 locations. Magazine printing contracts are either fixed-term or open-ended at fixed prices with, in some cases, adjustments based on certain criteria. Online Media Time Inc. New Media ("New Media"), the online unit of Time Inc., is one of the largest creators of online digital content, producing electronic versions of TIME, PEOPLE, FORTUNE, MONEY, EN- TERTAINMENI" WEEKLY and LIFE. New Media also develops and manages new brands that are accessible only on the Internet, such as "Ask Dr. Weil" and "PasentTime". New Media launched the Pathfinder online network in November 1994 to provide easy access and simple navigation to Time Inc.'s websites. The sites generate revenue from advertising, subscription-based access and fee-based downloads to premium content, selected e-commerce offerings, and the licensing of digital content. In 1998, New Media agreed to make its heavily trafficked PEOPLE online content available exclusively on AOL's proprietary network starting in early 1999. TEEN PEOPLE has also entered into an exclusive arrangement with AOL. Also in 1999, Time Inc. announced that it will direct a major expansion of Time Warner's e-commerce effort. Direct Marketing Time Lije Time Life Inc. is one of the nation's largest direct marketers of continuity series of books, music and videos. In addition to continuity series, it sells single products and products in sets. Its products are sold by direct response, including mail order, television and telephone, through retail, institutional and learning channels, catalogs, and in some markets by independent distributors. Time Life products are currently sold in over 25 languages worldwide. Editorial material for its books is created by in-house staffs as well as through outside publishers. Music and video rights are acquired through outside sources and compiled internally into finished products. Time Life's domestic direct response fulfillment activities are conducted from a centralized facility in Richmond, Virginia. Fulfillment of other business lines is done through a combination of in-house and outside fulfillment companies. Book-of-the-Month Club Book-of-the-Month Club, Inc. ("BOMC") currently operates eleven distinct book clubs and two continuity businesses with a combined membership of more than 4.5 million. Two of the clubs, Book-of-the- Month Club and Quality Paperback Book Club, are general interest clubs; other clubs specialize in hisiory, business, children's books, women's lifestyle, spiritual, self-help and health topics, or the books of a particular author. In addition, multimedia, audio and video products and other merchandise are offered through the clubs. BOMC operates in over 40 countries worldwide. I-11 BOMC acquires the rights from publishers to manufacture and distribute books and then has them printed by independent printing concerns. BOMC operates its own fulfillment and warehousing operations in Mechanicsburg, Pennsylvania. American Family Publishers A wholly-owned subsidiary of Time Inc. is a 50% partner in the parent entity of American Family Publishers ("AFP"), whose principal business is selling magazine subscriptions through the use of sweep- stakes promotions. Time Inc. has no management role in the day-to-day operation of AFP's business. During 1998, a number of state attorneys general launched investigations of AFP's sweepstakes business, while other atttorneys general and private plaintiffs filed lawsuits that alleged AFP's mailings were misleading. AFP has entered into an assurance of voluntary compliance ("AVC") with a number of states, and has substantially revised the wording of its sweepstakes mailings to conform with the AVC. These matters have had a significant adverse impact on AFP's business. See also Item 3, "Legal Proceedings" for additional information about the AFP matters. Books Trade Publishing Time Inc.'s trade publishing operations are conducted primarily by Time Warner Trade Publishing Inc. through its two major publishing houses, Warner Books and Little, Brown. In 1998, Time Warner Trade Publishing placed 31 books on The New York Times best-seller lists. Warner Books Warner Books primarily publishes hardcover, mass market and trade paperback books. Among its best selling hardcover books in 1998 were "Simple Abundance," by Sarah Ban Breathnach; "The Weaver," by David Baldacci and "The Celestine Vision," by James Redfield. Best selIing mass market paperbacks in 1998 included "Jack & Jill," by James Patterson; "The Notebook," by Nicholas Sparks and "Blood Work," by Michael Connelly. Time Warner Audiobooks develops and markets audio versions of books and other materials published by both Warner Books and Little, Brown. Little, Brown Little, Brown publishes general and children's trade books. Through its subsidiary, Little, Brown and Company (U.K.) Ltd., it also publishes general hardcover and mass market paperback books in the United Kingdom. Among the trade hardcover best-sellers published by Little, Brown in 1998 were: "Cat & Mouse," by James Patterson; "Making Faces," by Kevyn Aucoin and "The Dark Side of Camelot," by Seymour M. Hersh. Little, Brown handles book distribution for itself and Wamer Books as well as other publishers through its new state-of-the-art distribution center in Indiana. The marketing of trade books is primarily to retail stores and wholesalers throughout the United States, Canada and the United Kingdom. Through their combined United States and United Kingdom operations, Little, Brown and Warner Books have the ability to acquire English-language publishing rights for the distribution of hard and soft-cover books throughout the world. Oxmoor House and Sunset Books Oxmoor House, Inc., a subsidiary of Southern Progress, markets how-to books on a wide variety of topics including food and crafts, and Leisure Arts, Inc., also a subsidiary of Southern Progress, is a well-established publisher and distributor of instructional leaflets, continuity books series and magazines for the needlework and crafts markets. Sunset Books, the book publishing division of Sunset Publishing, markets books on topics I-12 such as building and decorating, cooking, gardening and landscaping, and travel. Sunset Books' unique marketing formula includes an extensive distribution network of home repair and garden centers. Postal Rates Postal costs represent a significant operating expense for the Company's publishing activities. In January 1999, the United States post office raised postal rates for all classes of mail. Publishing operations strive to minimize postal expense through the use of certain cost-saving measures, including the utilization of contract carriers to transport books and magazines to central postal centers. It has been the Company's practice in selling books and other products by mail to include a charge for postage and handling, which is adjusted from time to time to partially offset any increased postage or handling costs. Competition Time Inc.'s magazine and Internet media operarions compete for audience and advertising with numerous other publishers and retailers, as well as other media. These businesses compete for advertising directed at the general public and also advertising directed at more focused demographic groups. Time Inc.'s book publishing operations compete for sales with numerous other publishers and retailers as well as other media. In addirion, the acquisirion of publication rights to important book titles is highly comperirive, and Warner Books and Little, Brown compete with numerous other book publishers. TDS and WPS compete directly with other distributors operaring throughout the United States and Canada in the distriburion of magazines and paperback books. Time Inc.'s direct mazketing operations compete with other direct marketers through all media for the consumer's attention. In addition to the traditional media sources for product sales, the Internet is becoming a strong vehicle in the direct mazketing business. ENTERTAINMENT The Company's Entertainment businesses produce and distribute theatrical motion pictures, television shows, animation and other programming, distribute bome video product, operate The WB Television Network, maintain advertiser-supported entertainment sites on the Internet, license rights to the Company's characters, operate retail stores featuring coasumer products based on the Company's characters and brands, operate theme parks and morion picture theaters internationally and also produce and distribute recorded music. All of the foregoing businesses are principally conducted by Warnei Bros., which is a division of TWE, except the recorded music business which is wholly owned by the Company and is not part of TWE. The filmed entertainment business also includes New Line Cinema Corporation ("New Line") and Castle Rock Entertainment ("Castle Rock"), as well as the Turner libraries, which include Hanna-Barbera, MGM, RKO and classic Warner Bms. films and animated shorts. These businesses are wholly owned by the Company and are not a part of TWE, although TWE performs and is compensated for certain distriburion and other services for many of these businesses. The Company, through its wholly owned Warner Music Group division ("WMG"), is in the business of discovering and signing musical artists and manufacturing, packaging, distributing and marketing their recorded music. WMG also operates Warner/Chappell, a wholly owned music publishing business with offices around the world, and is a joint venture partner of music and video clubs in North America through its 50% ownership of The Columbia House Company. The Company's Entertainment operations are conducted in the United States and around the world. During 1998, approximately 42% of worldwide theatrical revenues and more than 52°�0 of WMG's recorded music revenues were generated outside the United States. I-13 Filmed Entertainment — Warner Bros. Warner Bros. Feature Films Warner Bros. produces feature films both wholly on its own and under co-financing arrangements with other motion picture companies. Warner Bros. also acquires for distribution completed films produced by others. Acquired distribution rights may be limited to specified territories, media and/or periods of time. The terms of Wamer 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. In some eases, producers, directors, actors, writers and others participate in the proceeds generated by the motion pictures in which they are involved. Feature films are licensed to exhibitors under contracts that provide for the length of the engagement, rental fees, which may be either a percentage of box ofiice receipts, with or without a guarantee of a fixed minimum, or a flat sum and other relevant terms. The number of feature films that a particular theater exhibits depends upon its policy of program changes, the competitive conditions in its area and the quality and appeal of the feature films available to it. Warner Bros. competes with all other distributors for playing time in theaters. In response to the rising cost of producing theatrical .films, Warner Bros. has signed joint venture agreements with several companies to co-finance films, decreasing its financial risk while retaining substan- tially all worldwide distribution rights. Warner,Bros. and Canal Plus have formed a joint venture, known as Bel-Air Entertainment, to co-finance on primarily a 50/50 basis the production, overhead and development costs of a total of approximately 10 to 20 motion pictures through 2003. Warner Bros. acquired all distribution rights in the U.S. and Canada and substantially all international distribution rights to these pictures. Warner Bros. will advance marketing and distribution costs in the territories where it distributes and will receive a distribution fee in connection with the exploitation of the pictures. "Message in a Bottle" was released under a separate arrangement with Bel-Air in the first quarter of 1999. In 1998 Warner Bros. entered into an agreement with Village Roadshow Pictures ("VRP") to co-finance under a cost sharing arrangement the production of up to 20 motion pictures over a five-year period. Approximately 50% of the production costs of those pictures will be provided by Wamer Bros. and the balance will be provided by VRP. Warner Bros. will acquire all distribution rights in the U.S. and Canada and substantially all intemational distribution rights to the co-financed pictures. Warner Bros. will advance marketing and distriburion costs in the territories in which it distributes and will receive a distribution fee in connection with the exploitation of the pictures. "Practical Magic" was cafinanced under this amangement and distributed by Wamer Bros. during 1998. Among others, "Analyze This," "Gossip," "Three Kings" and "The Matrix" are scheduled for release in 1999. Warner Bros. and Polygram Filmed Entertainment ("Polygram") have agreed ta co-finance on a 50/50 basis through 2000 the production, overhead and development costs of motion pictures produced or acquired by Casfle Rock, a subsidiary of Time Warner. Warner Bros. and Polygram (now Universal Studios) will each acquire distribution rights in the U.S. and Canada to half of the Castle Rock pictures and international distribution rights to the other half on an alternating basis. Wamer Bros. and Polygram will each advance mazketing and distribution costs in connection with the exploitation of the Castle Rock pictures. During 1998, Warner Bros. distributed "The Last Days of Disco," internationally, under this amangement. Among the Castle Rock releases anticipated for 1999 are "Mickey Blue Eyes" and "The Green Mile," which will be distributed by Warner Bros. domestically: Warner Bros. has extended the term of its distribution servicing agreements with Morgan Creek Productions Inc. ("Morgan Creek") through up to June 2003 pursuant to which, among other things, Warner Bros. provides domesric distribution services for all Morgan Creek pictures for a period of ten years from delivery of a picture, and certain foreign distribution services for selected pictures. Under this arrangement, Warner Bros. released "Wrongfully Accused," "Incognito" and "Major League 3" in 1998. I-14 Warner Bros.' cafinancing and distribution agreement with Monarchy Enterprises C.V. and Regency Entertainment U.S.A. ("Monarchy/Regency") expired in 1998. Warner Bros. distributed "Dangerous Beauty" and "The Negotiator" for Monarchy/Regency and released "City of Angels" as a co-financed picture with them in 1998. During 1998, Warner Bros. released 27 motion pictures for theatrical exhibition, of which 15 were produced by or with others and four were released solely in international markets. The following motion pictures, among others, were released by Warner Bros. in 1998: "City of Angels," "Lethal Weapon 4," "Practical Magic," "A Perfect Murder" and "You've Got Mail." During 1999, Warner Bros. expects to release appro�cimately 22 motion pictures, of which 14 are expected to be produced by or with others. In addition to the cafinanced pictures mentioned above, during 1999 Warner Bros. will release "True Crime," "Wild, Wild West" and "Eyes Wide Shut." Home Video Warner Home Video ("WHV") distributes for home video use pre-recorded videocassettes and digital video discs ("DVDs") containing the filmed entertainment product of (i) Warner Bros., (ii) Home Box Office, (iii) WarnerVision Entertainment, (iv) Castle Rock and (v) New Line Cinema. In March 1999, WHV and MGM agreed to temunate the parties' video distribution agreement. WHV will receive $225 million plus, effective January 1, 1999, video distribution rights in the Tumer Entertainment library, which includes all of the classic pre-1948 Warner Bros. and pre-1986 MGM films. In retum, MGM was granted early termination, effective January 31, 2000, of WHV's rights with respect to the United Artists film library and post-1986 MGM video product. WHV also distributes other companies' product for which it has acquired home video distribution or servicing rights. In 1998, WHV commenced distributing DVDs on behalf of Disney in Europe, the Middle East and Africa. WHV sells its product in the United States and in major intemational territories to retailers and wholesalers through its own sales force, with warehousing and fulfillment handled by divisions of Warner Music Group and third parties. In some intemational countries, WHV's product is distributed through licensees. Videocassette product is generally manufactured under contract with independent duplicators. DVD product is replicated by Warner Music Group'companies and third parties. During 1998, WHV released five titles in North America for home rental with sales and licensed units exceeding 400,000 units each: "Lethal Weapon 4," "L.A. Confidential," "Devil's Advocate," "City of Angels" and "U.S. Marshals." WHV entered into revenue sharing license agreements with rental customers, including distributors, in 1998. Under such agreements, WHV licenses video product and shares in revenues generated by its customers. Addirionally, WHV released nine tides in the North American sell-through market which generated sales of more than one million units each. Internationally, the following titles generated substantial home video revenue in 1998: "Tomorrow Never Dies," "Conspiracy Theory," "Contact," "L.A Confidential" and the first four seasons of the television series "Friends." DVDs, capable of storing large volumes of digitized information — enough storage capacity for two full- length feature films on a double-sided or dual-layered disc — increased their presence in North American markets during 1998. The DVD technology offers picture quality significantly superior to existing home video technology as well as premium features such as multiple language soundtracks. WHV is currendy benefiting by releasing in DVD format both first-run feature motion pictures and ritles from WHV's extensive catalogue. At year-end 1998, WHV had DVD distribution in major intemational temtories. Television Wamer Bros. is the leading supplier of television programming in the world. Warner Bros. both develops and produces new television series, made-for-television movies, mini-series, reality-based entertainment shows and animation programs and also distributes television programming for exhibition on all national networks, syndicated domestic television, cable syndication and a growing azray of international television distribution outlets. The distribution library owned or managed by Warner Bros. currently has some 5,700 feature films, I-15 32,000 television tifles, 12,000 animated titles and 1,500 classic animated shorts, including classic MGM and RKO titles such as "The Wizard of Oz" and "Gone With The Wind," as well as animation from Hanna- Barbera and MGM. Warner Bros. acts as distributor of the programming owned by subsidiaries of TBS. Warner Bros.' television programming is primarily produced by Warner Bros. Television, which produces dramatic and comedy programming, and Telepictures Productions ("Telepictures"), which specializes in reality-based and talk/variety series. During the 1998-1999 season, Warner Bros. Television launched several new network primetime series, including "Jesse," "Whose Line is it Anyway" and "Two of a Kind." Returning network primetime series included, among others, the top-rated series "ER" and "Friends," "The Parent Hood" and "The Wayans Bros." (each in its fifth season); "The Drew Carey Show" (in its fourth season); "Suddenly Susan" (in its third season); and "Veronica's Closet" and "For Your Love" (in their second season). Telepictures is responsible for the development and production of original programming primarily for syndicated television. In this capaciTy, Telepictures has successfully launched "The Rosie O'Donnell Show" (third season), "T'he Jenny Jones Show" (eighth season), "EXTRA" (fifth season), and "Change of Heart" (first season). Warner Bros. Television Animation ("WBTA") is responsible for the creation, development and production of contemporary television animation, as well as for the creative use and production of classic animated characters from Warner Bros.', TBS's and DC Comic's libraries, including "Looney Tunes" and the Hanna-Barbera and MGM libraries. Animation programming is important to the Company as a foundation for various product merchandising and marketing revenue streams as well as being an important source of initial and on- going programming for various distribution outlets, including those owned by the Company (including Cartoon Network and Kids' WB!). WBTA continues to be a leading producer of original children's animation programming and direct-ta video projects, with such programs as "Steven Spielberg Presents Pinky, Elmyra & The Brain," "The New Batman/Superman Adventures" and "Batman Beyond." WBTA also distributes "Pokemon" in the U.S. and manages production of, among others, the Cartoon Network series "Cow and Chicken," "Johnny Bravo," "Powerpuff Girls" and "I Am Weasel." Direct-to-video projects for 1999 include "Steven Spielberg Presents Animaniacs: Wakko's Wish" and a second Scooby-Doo feature-length video. The expansion of of%network, pay-per-view, pay and basic cable and satellite broadcasting has increased the distribution opportunities for feature films and television programming of all varieties from the Warner Bros. and TBS libraries. A typical sale of a new program series produced by or for Warner Bros. Television to a major domestic network grants that network an option to carry such program series for four years, after which time Warner Bros. Television can enter into a new'license agreement with that or any other network as well as license the already-broadcast episodes into off-network syndication (broadcast and/or cable). New series are also licensed concurrently into the international marketplace and can, after a short period of time, be sold in part or in whole on home video. Warner Bros.' domestic distribution operation handles the launching and supporting of first-run series produced directly for syndication, as well as the sale of movie packages, off- network syndication strips (in which shows originally produced for weekly broadcast on a network are aired five days a week), and reruns of classic television series for cable and satellite broadcasting. The top-ratecl series "ER" and "Friends" debuted in syndication in September 1998. Other television programs currently in off-network syndication include, among others, "Murphy Brown," "Full House," "The Fresh Prince of Bel Air" and "Family Matters." Warner Bros. International Television Distribution ("WBITD") is the world's largest distributor of feature and television programming for television exhibition outside of the United States. WBITD distributes programming in more than 175 countries and in more than 401anguages. The introduction of new technologies and programming services throughout the world has created many new opportunities for WBITD. In conjunction with these new services seeking Warner Bros.' programming, WBITD has formed strategic alliances with some of the world's leading satellite, ca61e and over-the-air television broadcasters, and has also commenced the development and production of television programming with international partners. In 1998, I-16 Warner Bros. formed a joint venture with Nippon 'Television Network, Toshiba and TWE Japan to produce and distribute movies and television programs in Japan and worldwide. Warner Bros.' backlog, representing the amount of future revenue not yet recorded from cash contracts for the licensing of theatrical and television product for pay cable, network, basic cable and syndicated television exhibition, amounted to $2.298 billion at December 31, 1998 (including amounts relating to the licensing of product to Time Warner's and TWE's cable television networks of $769 million as of December 31, 1998). The backlog excludes advertising barter contracts. See also "Management's Discussion and Analysis of Results of Operations and Financial Condition — Filmed Entertainment Backlog" at page F-18 herein. Consumer Products and Warner Bros. Studio Stores Warner Bros. Consumer Products licenses rights in both domestic and intemational markets to the names, photographs, 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 and Turner classic films. At December 31, 1998, Warner Bros. Studio Stores was operating more than 180 stores in the United States and in 15 countries or territories throughout the world, including 44 stores owned by international franchisees. Theaters Through joint ventures, Warner Bros. International Theaters operates approximately 90 multi-screen cinema complexes with approximately 800 screens in seven foreign countries, including 30 theaters in Australia, 22 in the United Kingdom, 20 in Japan, eight in Portugal, four in Italy and four in Spain. During 1999, Warner Bros. Intemational Theaters plans to open more than 15 cinemas with over 150 screens. Filmed Entertainmeat — TBS Theatrical films are also produced by New Line and Casde Rock, which are wholly owned subsidiaries of TBS and not a part of TWE. New Line is a leading independent producer and distributor of theatrical motion pictures. During 1998, through its two film divisions, New Line Cinema and Fine Line Features, New Line releases included "Rush Hour," "The Wedding Singer," "Lost in Space," "Blade" and "Pleasantville." For 1999, New Line anticipates that it will release, among others, "Austin Powers: The Spy Who Shagged Me," "Town & Country" and "The Bachelor." Castle Rock's films are currently being co-financed and distributed under an amangement with Warner Bros. and Polygram (see also, "Filmed Entertainment — Warner Bros." above). Castle Rock Television produced the critically acclaimed and highly rated Emmy award winning series "Seinfeld" for the past ten years. The series, which is distributed by a third party for a fee, began its first domestic syndication cycle in September 1995 and also continues to be aired throughout the world. In 1998 it was successfully sold to broadcast television stations for a second syndication cycle commencing in 2001 as well as to TBS Superstation for basic cable exhibition commencing in 2002. TBS's filmed entertainment business also includes the Hanna-Barbera, MGM and RKO libraries, which include classic films such as "The Wizard of Oz" and "Gone With the Wind" and cartoons such as the "Flintstones," "Yogi Bear," "Huckleberry Hound" and "Tom & Jerry." Distribution of these libraries is managed by Warner Bros. TBS's backlog, representing the amount of future revenue not yet recorded from cash contracts for the licensing of theatrical and television product for pay cable, network, basic cable and syndicated television exhibition, amounted to $636 million at December 31, 1998 (including amounts relating to the licensing of film product to Time Warner's and TWE's cable television networks of $226 million). The backlog excludes advertising barter contracts. See also "Management's Discussion and Analysis of Results of Operations and Financial Condition - Filmed Entertainment Backlog" at page F-18 herein. I-17 The WB Television Network The WB Television Network ("The WB") completed its fourth year of broadcast operations in January 1999. During the 1998/99 broadcast season, The WB expanded its prime time program line-up to five nights and is now airing 11 hours of series programming from Sunday to Thursday nights. The network's line-up includes the family series "7th Heaven," as well as programming aimed at a teen and young adult audience, such as "Dawson's Creek," "Charmed," "Buffy the Vampire Slayer," and the Golden Globe award winning "Felicity." During 1998, The WB's broadcast coverage (with 88 over-the-air affiliates) grew to approximately 90% of U.S. TV households with the addition of key affiliates in Pittsburgh, Cincinnati, Baltimore, San Antonio and Oklahoma City. The WeB, a distribution alliance for The WB, was launched in September 1998 in smaller broadcast markets. WeB programming is distributed to local broadcast affiliates who then disseminate WeB programming via local cable systems. The WB's children's network, Kids' WB!, airs 19 hours of programming per week with programming on weekday mornings, weekday afternoons and Saturday mornings. Tribune Broadcasting owns a 22.25% interest in The WB. Key employees of The WB hold an 11% interest in the network. Warner Bros. Online Warner Bros. Online, established in 1995, is responsible for all of Warner Bros. commercial advertiser- supported online initiatives and, according to Media Metrix, has established itself as one of the most-visited studio sites on the Internet. The division recently entered into a joint venture with FortuneCity.com, called ACMEcity.com, to create a global advertiser-supported community network which will enable fans of Warner Bros. movies, music and television shows to build personal home pages. In connection with the formation of this joint venture, Warner Bros. received equity in FortuneCiTy.com equal to approximately 13% of its outstanding shares. In the second quarter of 1999, Warner Bros. Online plans to launch a vertical advertiser-supported entertainment portal called "Entertaindom" to be co-branded and distributed in partnership with computer manufacturers, Internet service providers and portal sites. Entertaindom will offer entertainment information and services, as well as a mix of content, community sites and e-commerce, featuring video-based entertainment, animation, music and multiplayer games. Warner Bros. Online is currently producing broadband interactive entertainment in the form of WebDVD shows and content for broadband networks. Recorded Music In the United States, WMG's recorded music business is principally conducted through W1VIG's Warner Bros. Records, Inc., Atlantic Recording Corporation, Elektra Entertainment Group Inc. and Sire Records Group Inc. and their affiliated labels, as well as through the WEA Inc. companies. The WEA Inc. companies include WEA Manufacturing Inc., which manufactures compact discs (CDs), audio and videocassettes, CD-ROMs and DVDs for WMG's record labels, Warner Home Video and for outside companies; Ivy Hill Corporation, which produces printed material and packaging for WMG's recorded music products as well as for a wide variety of other consumer products; and Warner-Elektra-Atlantic Corporation ("WEA Corp."), which markets and distributes WMG's recorded music products to retailers and wholesale distributors. WMG also owns a majority interest in Alternative Distribution Alliance ("ADA"), a so-called "independenY' distribution company specializing in alternative rock music with a focus on new artists and smaller retailers. WMG's recorded music activities are conducted in more than 60 countries outside the United States by Warner Music International and its subsidiaries, affiliates and non-affiliated licensees. I-18 Domestic WMG's record labels in the United States — Warner Bros., Atlantic, Elektra and Sire — each with a distinct identity, discover and sign musical artists. The labels scout and sign talent in many different musical genres, including pop, rock, jazz, country, hip hop, reggae, folk, blues, gospel and Christian music. Artists generally receive royalties based upon the sales of their recordings and music videos, and many receive non- refundable advance payments recoupable from such royalties. WMG is a vertically-integrated music company. After an artist has entered into a contract with a WMG label, a master recording of the artist's music is produced and provided to WMG's manufacturing operation, WEA Manufacturing, which replicates the music primarily on CDs and audio cassettes. Ivy Hill prints material that is included with CDs and audio cassettes and creates packaging for them. WEA Corp. and ADA, WMG's distribution arms, sell product and deliver it, either directiy or through sub-distributors and wholesalers, to thousands of record stores, mass merchants and other retailers throughout the country.� CDs and tapes are also beginning to be sold directly to consumers through online retailers on the Internet, such as CD Now, Amazon.com and Columbia House's Total E. WMG, working with IBM and several other music companies, has announced a test of the digital distribution of music, named the Madison Project, which will seek to evaluate consumer interest in purchasing electronically distributed music via the Internet. At the same time a recording is being distributed, the label's promotion, marketing, advertising and publicity departments place advertisements in print and electronic media, work to get the new album played on the radio, reviewed and mentioned in publications and the artist booked for appearances on radio and television. If a music video featuring an artist has been produced, the video is distributed and promoted to music video outlets. Label personnel may also help organize a concert tour that will further promote a new album. In addition to newly released records, each of WMG's labels markets and sells albums from their extensive catalogues of prior releases, in which the labels generally continue to own the copyright in perpetuity. Rhino Records, which became wholly owned by WMG during 1998, specializes in compilations and reissues of previously released music. WMG also has entered into joint venture arrangements pursuant to which WMG companies manufac- ture, distribute and market (in most cases, domestically and internationally) recordings owned by the joint ventures. Such agreements typically provide a WMG label with an equity interest and a profit participation in the venture, with financing furnished either solely by the WMG label or by both parties. Included among these arrangements are the labels Maverick, Tommy Boy, Sub Pop, Qwest and 143 Records. WMG labels also enter into agreements with unaffiliated third-party record labels such as Curb Records to manufacture and distribute recordings that are marketed under the owner's proprietary label. Through a 50/50 joint venture, WMG and Sony Music Entertainment operate The Columbia House Company, the leading direct marketer of CDs, audio and videocassettes in the United States and Canada. According to Media Metrix, The Columbia House Internet sites are among the top 15 most visited retail sites on the Internet. Among the albums resulting in significant U.S. sales for WMG during 1998 were the City of Angels soundtrack and releases from matchbox20, Brandy, Madonna, Barenaked Ladies, Jewel, Alanis Morissette, Third Eye Blind and Metallica. Internatioaa! Operating in more than 60 countries around the world, Warner Music International ("WMI") engages in the same activities as WMG's domestic labels, discovering and signing artists and manufacturing, packaging, distributing and marketing their recorded music. The artists signed to WMI and its affiliates number more than a thousand. In most cases, WMI also markets and distributes the recordings of those artists for whom WMG's domestic record labels have international rights. In certain countries, WMI licenses to unaffiliated third-party record labels the right to distribute its recordings. I-19 WMI operates a plant in Germany that manufactures CDs, laser discs and vinyl records for its afi'iliated companies, as well as for outside companies and, as part of a joint venture, operates a plant in Australia that also manufactures CDs. WMI operates two video companies that coordinate the international release of music and non-music video titles. Among the artists whose albums resulted in significant sales for WMI in 1998 were Madonna, Enya, Alejandro Sanz, Eric Clapton and Tatsuro Yamashita. Music Publishing WMG's music publishing companies own or control the rights to more than one million musical compositions, including numerous pop music hits, American standards, folk songs, and motion picture and theatrical compositions.l"he catalogue includes works from a diverse range of artists and composers, including Phil Collins, Comden & Green, George and Ira Gershwin, Michael Jackson, Madonna and Cole Porter. Warner/Chappell also administers the music of several television and motion picture companies, including Lucasfilm, Ltd. and Samuel Goldwyn Productions. Warner/Chappell also owns Wamer Bros. Publications and CPP/Belwin, two of the world's largest publishers of printed music. These two companies market publications throughout the world containing the works of such artists as Alabama, The Grateful Dead, Led Zeppelin, Madonna, Bob Seger and many others. The principal source of revenues to Warner/Chappell is license fees paid for the use of its musical compositions on radio, television, in motion pictures and in other public performances; royalties for the use of its compositions on CDs, audio cassettes, music videos and in television commercials; and sales of published sheet music and song books. Other Entertainment Assets Theme Parks With local partners, Warner Bros. has developed movie-related theme parks in Australia and Germany which feature Warner Bros.' movie, cartoon and superhero characters. Warner Bros. has announced that it is studying the feasibility of operaring the first movie-based theme park in Spain. In April 1998, TWE sold its remaining 49% interest in Six Flags Entertainment Corporation ("Six Flags") to Premier Parks Inc. ("Premier"), a regional theme park operator. As part of the transaction, TWE will continue to license its animated cartoon and comic book characters to Six Flags's theme parks and will similarly license such rights to Premier's theme parks in the United States and Canada under a long-term agreement covering 25 existing and all future locations. See also Item 3, "Legal Proceedings" for information about certain litigation involving Six Flags. DC Comics and Mad Magazine TWE and Warner Communications Inc. ("WCI"), which is wholly owned by Time Warner, each own a 50% interest in DC Comics. DC Comics publishes more than 60 regularly issued comics magazines, among the most popular of which are "Superman," "Batman," "Wonder Woman" and "The Sandman," as well as collections sold as books. DC Comics also derives revenues from motion pictures, television, product licensing, books for juvenile and adult markets and foreign publishing. Time Warner wholly owns E.C. Publications, Inc., the publisher of MAD, a magazine featuring articles of humorous and satirical interest, which is regularly published 12 times a year and also in periodic special editions. I-20 Competition The production and distribution of theatrical motion pictures, television and animation product and videocassettes/videodiscs/DYDs are highly competitive businesses, as each competes with the other for viewers' attenrion, as well as with other forms of entertainment and leisure time activities, including video games, the Internet and other computer-related activities. Furthermore, there is increased compedtion in the television industry evidenced by the increasing number and variety of broadcast networks and basic cable and pay.television services now available. There is active competition among all production companies in these industries for the services of producers, directors, 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. Network television is extremely competitive as networks seek to attract audience share, television starions for affiliation, advertisers and broadcast rights to television programming. Warner Bros. competes in its character merchandising and other licensing and retail activities with other licensors and retailers of character, brand and celebrity names. Warner Bros.' operation of theaters is subject to varying degrees of competition with respect to obtaining films and attracting patrons. The recorded music business is highly competitive. The revenues of a company in the recording industry depend upon public acceptance of the company's recording artists and their music. Although WMG is one of the largest recorded music companies in the world, its compedtive position is dependent on its continuing ability to attract and develop talent that can achieve a high degree of public acceptance. Overexpansion of retail recorded music oudets in the U.S. over the past several years led to the closing of many such stores during 1996 and 1997, which has resulted in further increased competition among recorded music companies. The recorded music business continues to be adversely affected by counterfeiting of both audio cassettes and CDs, piracy and parallel imports and may be affected by consumers' ability to download quality sound reproductions from the Internet in sound files without authorization from the Company. In response, the recorded music industry is engaged in a coordinated effort to develop a secure technology for digital music delivery. In addition, the recorded music business also has competition from other forms of entertainment, such as television, pre-recorded videocassettes, the Internet and computer and video games. Competition in the music publishing business is intense. Although WMG's music publishing business is one of the largest on a worldwide basis, it competes with every other music publishing company in acquiring musical compositions and in having them recorded and performed. I-21 CABLE The Company's Cable business consists principally of interests in cable television systems that, in general, are managed by Time Warner Cable, a division of TWE. Of the approximately 12.6 million subscribers served by the Company at December 31, 1998, approximately 1.8 million are in systems owned by TWI Cable Inc. ("TWI Cable"), a wholly owned subsidiary of Time Warner which is not a part of TWE, and approximately 10.8 million are in systems owned or managed by TWE. TWE's cable systems include approximately 6.3 million subscribers in a joint venture between TWE and Advance/Newhouse known as TWE-A/N. Time Warner Cable generally manages all such systems and receives a fee for management of the systems owned by TWI Cable and TWE-A/N. As of March 1, 1999; 'TWE-A/N was owned 33.3% by Advance/Newhouse, 64.8% by TWE and 1.9% by TWI Cable. Systems Operations Time Warner Cable is the largest operator of cable television systems in the United States. As of December 31; 1998, 82% of Time Warner Cable customers were served by clustered cable systems (as described below) with 100,000 subscribers or more, and approximately 70% of Time Warner Cable's systems have been upgraded for higher channel capacity and new and advanced services. Over the past several years, Time Warner Cable has pursued a strategic goal of upgrading its cable systems generally to 750 MHz capability, based on a hybrid fiber optic/coaxial cable architecture. Those systems not upgraded to 750 MHz will be upgraded to a level of 550 MHz. Upgraded systems can deliver increased channel capacity and provide two-way transmission capability, with improved network management systems. The system architecture is also flexible, in that system capacity for future needs can be expanded by various means without major additional capital expenditures. Approximately 70% of Time Warner Cable's systems had completed upgrades by December 31, 1998. These upgrades have enabled Time Warner Cable to expand its core cable programming, so that average channel capacity of Time Warner Cable systems has generally increased from approximately 50 channels to approximately 70 channels at the end of 1998. Over time, the upgrading will also permit Time Wamer Cable to roll out new and advanced services, including digital and high-definition television ("HDTV") program- ming, high-speed Internet access, telephony and other services including videaon-demand. See "Cable — New Cable Services" below. Time Warner Cable entered into a Social Contract with the Federal Communications Commission ("FCC") in 1996 that required upgrades of generally all domestic systems managed by Time Warner Cable by December 31, 2000. The total capital investment to be made by Time Wamer Cable for the upgrades is estimated to be approximately $4 billion of which, by the end of 1998, approximately $3 billion had been spent. Time Warner Cable believes that its clustering strategy has enabled, among other things, significant cost and marketing efficiencies, more effective pursuit of local and regional cable advertisers, the development of local news cliannels and the roll-out of advanced services over a geographically concentrated customer base. Several transactions entered into or completed in 1998 or scheduled to close in 1999 will further Time Warner Cable's clustering strategy. As of December 31, 1998, Time Warner Cable had 33 distinct geographic system groupings, each serving more than 100,000 subscribers. During 1998, TWE-A/N and subsidiaries of TCI Communications Inc. ("TCIC") formed a new 50-50 joint venture (the "Texas Venture") to provide cable television to the Houston area and to certain other communities in south and west Texas. The two partners each contributed systems serving approximately 550,000 subscribers to the Texas Venture, which is managed by Time Warner Cable. TCIC also contributed a cable television system serving approximately 95,000 subscribers to the existing Kansas City Cable Partners joint venture. In November 1998, Time Warner Cable entered into a series of asset exchange agreements with certain subsidiaries of TCIC under which TCIC will receive systems serving approximately 575,000 subscribers in areas not strategic to Time Warner Cable and Time Warner Cable will receive systems serving approximately 625,000 subscribers adjacent to or near major clusters in Florida, Hawaii, Maine, New York, I-22 Ohio, Texas and Wisconsin. These trades aze expected to close periodically throughout 1999, subject to obtaining required regulatory approvals. Franchises Cable systems are constructed and operated under non-exclusive franchises granted by state or local governmental authorities. Franchises typically contain many conditions, such as time limitations on com- mencement or completion of construction; conditions of service, including number of channels, provision of free services to schools and other public institurions; and the maintenance of insurance and indemnity bonds. Cable franchises are subject to various federal, state and local regulations. See "Regulation and Legislation" below. Programming Programming is generally made available to customers through programming tiers, which are packages of different programming services provided, for prescribed monthly fees. The available analog channel capacity of Time Warner Cable's systems has been expanding as system upgrades are completed. Digital services will further increase the number of channels of video programming a customer may elect to receive. Video programming available to customers includes local and distant broadcast television signals, cable programming services like CNN, TNT and ESPN, and premium cable services like HBO, Cinemax, Showtime and Starz! The terms and conditions of carriage of programming services are generally established through programming affiliation agreements with Time Warner Cable. Many programming services impose a monthly license fee per subscriber upon the cable operator. Programming costs generally have been increasing sharply in recent years and depending on the terms of any specific agreement, the cost of providing any cable programming service may continue to rise. While Time Warner Cable sometimes has the right to cancel contracts, and can in any event refuse to renew them, it is unknown whether the loss of any one popular supplier would have a material adverse effect on Time Warner Cable's operations. Service Charges and Advertising Subscribers to the Company's cable systems are chazged monthly fees based on the level of service selected. The monthly prices for various levels of cable television services (excluding services offered on a per- channel or per-program basis) range generally from $8 to $30 for residential customers. Other services offered include equipment rentals, for an additional monthly fee. A one-time installation fee is generally charged for connecting subscribers to the cable television system. Although regulation of certain cable programming rates is scheduled to "sunset" on March 31, 1999, rates for "basic" programming and for equipment and installation will continue to be regulated pursuant to federal law. See "Regulation and Legislation" below. Subscribers may purchase premium programming services and, in certain systems, other per-channel services, for an additional monthly fee for each such service, with discounts generally available for the purchase of more than one service. Pay-per-view programming offers movies and special events, such as boxing, for a separate chazge. Systems offering pay-per-view movies generally charge between $3 and $4 per movie, and systems offering pay-per-view events charge between $6 and $50, depending on the event. Time Warner Cable's systems increasingly offer pay-per-view services on an"impulse" basis, permitting a subscriber to place an order over the cable system through his or her remote control or cable set-top box. Subscription revenues continue to account for most of Time Warner Cable's revenues, with pay-per-view and premium services contributing additional revenues. Subscribers may discontinue purchasing services at any time. 'Iime Warner Cable also generates revenue by selling advertising time to national, regional and local businesses. Cable television operators receive an allocation of advertising time availabilities on certain cable programming services into which commercials can be inserted at the local system level. In this regard, Time Warner Cable competes against broadcast T'V stations, radio stations and newspapers for a share of local media revenues. The clustering of Time Warner Cable's systems expands the reach of viewers to cable I-23 programs over the local area and helps local ad sales personnel to compete more effectively. In addition, in many localities, contiguous cable system operators have formed advertising interconnects to deliver locally inserted commercials across wider geographic areas, replicating the reach of the broadcast stations as much as possible. Fifteen of Time Warner Cable's 43 field divisions participate in a cable advertising interconnect. Loca! News Channels Time Warner Cable operates 24-hour local news channels in New York City (NY1 News), Tampa Bay (Bay News 9), Orlando (Central Florida News 13) and Rochester, NY (R/News) and has announced that its fifth local news channel will launch in Austin, Texas in the summer of 1999. Local news programming increases local advertising revenues. Further, Time Warner Cable believes that providing news programming specifically focused on a local region strengthens its ability to compete with other multichannel video providers operating in the region. New Cable Services Road Runner In June 1998, TWE, TWE-A/N, TWI Cable, MediaOne, and subsidi.aries of Microsoft Corp. ("Microsoft") and Gompaq Computer Corp. ("Compaq") formed a joint venture to operate and expand Time Warner Cable's and MediaOne's existing high-speed online service business (the "Road Runner Joint Venture"). The Road Runner cable service provides high-speed Internet access and also offers original content for broadband-capable networks. Road Runner affiliates with local cable television system operators, principally Time Warner Cable and MediaOne, in exchange for a percentage of the cable operator's retail revenue from subscribers for the Road Runner service. Customers who elect to subscribe connect their personal computers to the Road Runner service for access at high speeds to the Internet and to Road Runner's content. The ownership of the equity in the Road Runner Joint Venture is presently as follows: TWI Cable — 10.7%, TWE — 25%, TWE-A/N — 32.9%, and MediaOne — 31.4%. In exchange for Microsoft and Compaq contributing $425 million to the Road Runner Joint Venture, Microsoft and Compaq each received a preferred equity interest in the Venture that is convertible into a 10% common equity interest. Accordingly, on a fully diluted basis, the.Road Runner Joint Venture is owned 8.6% by TWI Cable, 20% by TWE, 26.3% by TWE-A/N, 25.1% by MediaOne, 10% by Microsoft and 10% by Gompaq. See also Note 2, "Cable Transactions — Road Runner Joint Venture" to the Company's consolidated financial statements at page F-36 herein. As of December 31, 1998, the Road Runner Joint Venture had affiliations in 241ocations with access to 7 million cable homes and the service had approximately 180,000 subscribers. The Road Runner service has been launched by Time Warner Cable in the following areas: Albany, Austin, Binghamton, Charlotte, Columbus and Northeast Ohio, El Paso, Hawaii, Memphis, Portland, Rochester, San Diego, Syracuse and Tampa Bay. Roll-outs will continue during 1999. Digital Cable Services Following tesring in 1998 and early 1999,.Time Warner Cable will begin a roll-out of digital cable service for certain of its cable systems, including Austin, Texas, Tampa, Florida and Columbus, Ohio. The digital format of the signals allows compression of the signals so that they occupy less bandwidth. This substantially increases the number of channels that can be provided over a system, when compared to standard analog signals. Time Warner Cable's digital cable service will present customers with the option to subscribe to a new digital programming service providing up to 100 digital program networks and music services for a separate monthly fee. The programming on the digital set-top boxes delivered to subscribing customers will also offer more pay-per-view options, more channels of mulriplexed premium services, a digital interactive program guide, a digital programming tier, CD-quality music and other features such as parental lockout options. Digital service roll-outs are expected to increase over time as additional set-top equipment becomes available. I-24 f',ayri Pursuant to FCC order, each television broadcast station has been granted additional over-the-air spectrum to provide, under a prescribed roll-out schedule, high definition and digital television signals to the public. Depending on the speed with which HDTV and digital signals are developed, it can be expected that such signals will vie with the many other sources of programming for cable camage. In 1998, Time Warner Cable agreed to carry the high-definition television signals and other digital signals that will be broadcast by television stations owned and operated by the CBS network. Recent Events Proposed AT&T Joint Venture On February 1, 1999, the Company announced that it intended to form a joint venture with AT&T pursuant to which the joint venture will have the right for up to a 20-year term to offer AT&T-branded cable telephone service to residential and small business customers over Time Warner Cable's existing cable network. Under the preliminary terms announced by the parties, the joint venture will be 77.5% owned by AT&T and 22.5% owned by TWE, TWE-A/N and TWI Cable, collectively. The joint venture is expected to make payments to Time Warner Cable initially based on the number of homes included in the cable network that have been upgraded to fiber optic capacity and will pay a monthly fee during the term per telephony subscriber, subject to guaranteed minimums, and is expected to make future revenue sharing payments if the joint venture surpasses targeted monthly subscriber revenue levels. The joint venture is also expected to purchase telephony equipment and fund Time Warner Cai�le's expenses of installation and maintenance. It is expected that AT&T will fund all of the joint venture's negative cash flow. For additional information, see also "Management's Discussion and Analysis of Results of Operations and Financial Condition — Cable Strategy" at pages F-16 through F-18 herein. The joint venture is subject to the negotiation and execution of definitive agreements, approval of the final terms by MediaOne and Advance/Newhouse and certain regulatory and other approvals. Primestar In April 1998, TWE and Advance/Newhouse transferred the direct broadcast satellite ("DBS") operarions conducted by TWE and TWE-A/N and the 31% partnership interest in Primestar Partners, L.P. held by TWE-A/N to Primestar, Inc., a separate holding company ("Primestar"). Following Primestar's decision to abandon its proposed acquisition of certain high-power satellite assets from a joint venture between The News Corporation Ltd. and MCI Telecommunications Corp., due to inability to obtain regulatory• approvals, Primestaz recently entered into an agreement to sell Primestaz's medium-power DBS business and assets to Direcl'V, a competitor of Primestar owned by Hughes Electronics Corp. Also, Primestar, Primestar Partners, the stockholders of Primestar and Tempo Satellite, Inc. ("Tempo"), a wholly owned subsidiary of TCI Satellite Entertainment, Inc., entered into a second agreement with DirecTV, pursuant to which DirecTV will purchase high-power satellites from Tempo and Primestar and Primestar Partners will relinquish their respective rights to acquire or use such high-power satellites. The ultimate disposition of the medium-power assets of Primestar is subject to Primestar bondholders' and regulatory approvals and the disposition of certain of Tempo's high-power satellites is subject to regulatory approvals. There can be no assurance that such approvals will be obtained. For further information with respect to Primestar, see Note 2, "Cable Transactions — Primestar" to the Company's consolidated financial statements at pages F-36 and F-37 herein. Intemational In France, TWE and TWE-A/N own 100% of Cite Reseau and 49.9% of Rhone Vision Cable, both of which were established to acquire new franchises, build and operate cable systems in France. In Japan, TWE and TWE-A/N beneficially own, directly or indirectly, 25�90 of Titus Communications Corporation, which I-25 provides cable, telephony and Internet access service primarily in the Tokyo area, and 19.2% of Chofu Cable Television Company, which provides cable service in the suburban Tokyo area. Business Telephony In July 1998, TWE; TWE-A/N and TWI Cable combined the business telephony operations formerly owned by them into a new enrity named Time Warner Telecom LLC ("Time Warner Telecom") that is intended to be self-financing. Time Warner Telecom is a facilities-based competitive local exchange carrier ("CLEC") that offers a wide range of business telephony services in selected metropolitan markets across the United States. The equity interests of Time Warner Telecom are owned 61.98% by Time Warner, 18.85% by MediaOne and 19.17% by Advance/Newhouse. In connection with its formation in July 1998, Time Warner Telecom raised approximately $400 million in a public debt offering, the proceeds of which are being used by Time Wamer Telecom to further develop and expand its telephony networks and services and for general corporate and working capital purposes. In 'January 1999, Time Warner Telecom updated a previously filed, preliminary registration statement with the Securities and Exchange Commission to conduct an initial public offering of a minority interest of its common stock, subject to market and other conditions. Time Warner Telecom's customers are principally medium and�large-sized telecommunications-intensive business end-users, long distance carriers, Internet service providers, wireless communications companies and govemmental entities. Such customers are offered a wide range ,pf integrated telecommunications services, including dedicated transmission, iocal switched data and video transmission services and .certain Internet services. As of December 31, 1998, Time Warner'Telecom had deployed switches in 16 of its 19 metropolitan markets. Its networks have been constructed primarily .through licsnsing the use of fiber capacity from Time Warner Cable. Competition Cable television systems face strong competition for Siewer attention and subscriptions from a wide variety of news, information and entertainment providers. These include mulrichannel video providers like DTH, MMDS, SMATV systems and telephone companies, other sources of video programs (such as broadcast television and videocassettes) and additional sources for news, entertainment and information, including the Intemet. Cable television systems also face strong competition from all media for advertising dollars. DTK The FCC has awarded permits to several companies for orbital slots from which medium- or high-power Ku-Band DTH service can be provided. DTH services offer pre-packaged programming services that can be received by relatively small and inexpensive receiving dishes. As of June 1998, satellite-delivered DTH services were reported to be serving over 7.2 million subscribers. Echostar has announced that, unlike other DTH services, it will deliver some local broadcast stations in 'some areas. In addition to DTH, most cable programming is available to owners of larger, more expensive' C-Band satellite dishes ("TVROs"), either directly from the programmers or through third-party packagers. Legislation has been introduced in Congress to include carriage of local signals by DTH providers under the copyright compulsory license now granted to cable television operators. The ability of DTH services to deliver local signals bn an equal economic basis will eliminate a significant advantage that cable operators currently. have over DTH .providers. MMDS/Wireless Cable. Wire}ess cable operators, including digital wireless operators, use microwave technology to distribute video programming. Wireless cable has grown rapidly, reportedly servicing over 1.0 million subscribers nationwide as of June 1998. In recent years, the FCC has adopted rules to facilitate the use of greater numbers of channels by wireless cable operators. SMATY. Additional competition comes from private cable television systems servicing condominiums, apartment complexes and certain other multiple unit residential developments. The operators of these private systems, known as SMATV systems, often enter into exclusive agreements with apartment building owners or homeowners' associations which preclude franchised cable television operators from serving residents of such private complexes. Under the 1996 Telecommunications Act, a SMATV system is not a cable system as long I-26 as it uses no public right-of-way. SMATV systems of%r both improved reception of local television stations and many of the same satellite-delivered program services as of%red by franchised cable television systems. Overbuilds. Under the 1992 Cable Act, franchising authorities are prohibited from unreasonably refusing to award additional franchises. There are an increasing number of overlapping cable systems operating in Time Warner Cable franchise areas. Municipalities themselves are authorized to operate cable systems without a franchise. One municipally-owned system is presently in operation in a Time Warner Cable franchise area and several other municipalities have indicated an interest in operating a cable system. Telephone Companies. The 1996 ?elecommunications Act eliminated the restriction against ownership and operation of cable systems by local telephone companies within their local exchange service areas (subject to the restriction against acquisition of greater than lU% of existing cable systems described under "Regulation and Legislation — Ownership," below) . Telephone companies are now free to enter the retail video distribution business through any means, such as DTH, MMDS, SMATV or as traditional franchised cable system operators. Alternatively, the 1996 Telecommunications Act authorizes local telephone companies to operate "open video systems" subject to certain local authorizations, including payments to local governmen- tal bodies in lieu of cable franchise fees. Additional Competirion. In addition to multichannel video providers, cable television systems compete with all other sources of news, information and entertainment for viewer attention and for subscription revenues. This includes over-the-air television broadcast signals which a viewer is able to receive directly using the viewer's own television set and antenna. Cable systems also face comperition from alternative methods of distributing and receiving television signals and from other sources of entertainment such as live sporting events, movie theaters and home vid�o products, including videocassette recorders, and the Internet. In recent years, the FCC has adopted policies providing for authorization of new technologies and a more favorable operating environment for certain e�cisting technologies that provide, or may provide, substantial additional competition for cable television systems. REGULATION AND LEGISLATION The Company's cable television systems, cable network, television network and original programming businesses are subject, in part, to regulation by the FCC, and the cable television systems business is also subject to regulation by some state govemments and substantially all local governments. The following is a summary of current federal laws and regulations affecting the growth and operation of these businesses and a description of certain state and local laws. In addition, various legislative and regulatory proposals under consideration from time to dme by Congress and various federal agencies have in the past materially affected, and may in the future materially af%ct, the Company. Programming and Cable Networks The Telecommunications Competition and Deregulation Act of 1996 (the "1996 Telecommunications Act") eliminated the restrictions on the number of television stations that one entity may own and increased the national audience reach limitation by one entity from 253o to 35°k of U.S. television households. As required by the 1996 Telecommunications Act, the FCC revised its dual network rule to allow a TV station to af�iliate with an entity maintaining two or more networks, unless certain limited circumstances pertain. The FCC rules currently prohibit an entity from having an attributable interest in two local TV stations with overlapping specified signal contours. In an ongoing rulemaking proceeding, the FCC has proposed to relax this rule in certain circumstances and sought comment on a possible waiver mechanism. In another rulemaking, the FCC has sought comment on possible changes to its attribution rules, which define the type of interests in television stations that are recognizable for purposes of its ownership rules. Under one such proposal, certain currently nonattributable debt or passive equity interests would become attributable if held in conjunction with certain other interests in or relationships with the TV licensee, such as the provision of programming. Such a proposal, if adopted, could adversely affect The WB's efforts to add new television stations as afiiliates. I-27 Under the 1992 Cable Act, the FCC has issued regulations which generally prohibit vertically integrated programmers, which cunently include the Turner Networks and the Home Box Office Services, from offering different prices, terms, or conditions to competing multichannel video programming distributors unless the differential is justified by certain permissible factors set forth in the regularions. The rules also place certain restrictions on the ability of vertically integrated programmers to enter into exclusive distribution arrange- ments with cable operators. The 1996 Telecommunications Act also contains certain provisions relating to violent and sexually explicit programming. First, the statute requires manufacturers to build television sets with the capability of blocking certain coded programming (the so-cailed "V-chip"). The FCC has adopted rules requiring television manufacturers to include blocking technology in at least half of their new product models with a picture screen of 13 inches or greater by July 1, 1999; the remaining such models will be required to contain blocking technology by January 1, 2000. Second, the 1996 Telecommunications Act gave the cable and broadcasting industries one year to develop voluntary ratings for video programming containing violent, sexually explicit or other indecent content and to agree voluntarily to transmit signals containing such ratings. In March 1998, the FCC determined that the system of voluntary parental guidelines adopted by television broadcasters, networks and program producers, and cable systems and networks, was acceptable and in compliance with the 1996 Telecommunications Act. Cable The following discussion summarizes the significant federal, state and local laws and regulations affecting the Company's cable television systems operations. . Federal Laws. The Cable Communications Policy Act of 1984 ("1984 Cable Act"), the 1992 Cable Act and the 1996 Telecommunications Act are the principal federal statutes governing the cable industry. These statutes regulate the cable industry, among other things, with respect to: (i) cable system rates for both basic and certain nonbasic services; (ii) programming access and exclusivity arrangements; (iii) access to cable channels for public, educational and governmental programming; (iv) leased access terms and conditions; (v) horizontal and vertical ownership of cable systems; (vi) consumer protection and customer service requirements; (vii) franchise renewals; (viii) television broadcast signal carriage requirements and retransmission consent; (ix) technical standazds; and (x) privacy of customer information. Federal Regulations. The FCC, the principal federal regulatory agency with jurisdiction over cable televisi�n, has promulgated regulations implementing the federal statutes. Rate Regulation. Under federal laws, nearly all cable television systems are subject to local rate regulation of basic service pursuant to a formula established by the FCC and enforced by local franchising authorities. Additionally, the 1992 Cable Act required the FCC to review rates for nonbasic service tiers, known as "cable programming service riers" ("CPST'), comprised of cable programming services other than per-channel or per-program services, in response to complaints filed by franchising authorities; prohibited cable television systems from requiring subscribers to purchase service tiers above basic service in order to purchase premium service if the system is technically capable of doing so; required the FCC to adopt regulations to establish, on the basis of actual costs, the price for installation of cable service and rental of cable equipment; and allowed the FCC to impose restrictions on the retiering and rearrangement of basic and CPST services under certain limited circumstances. Under the 1996 Telecommunications Act, regulation of CPST rates is scheduled to terminate on March 31, 1999. Regulation of both basic and CPST rates also ceases for any cable system subject to "effective competition." The 1996 Telecommunications Act expanded the definition of "effective competi- tion" to cover situations where a local telephone company or its affiliate, or any multichannel video provider using telephone company facilities, offers comparable video service by any means except direct-to-home ("DTH"). The FCC has found Time Warner Cable to be subject to "effective competition" in certain jurisdictions. I-28 The FCC's rate regulations employ a benchmark system for measuring the reasonableness of existing basic and CPS? service rates. Alternatively, cable operators have the opportunity to make cost-of-service showings which, in some cases, may justify rates above the applicable benchmarks. The regulations also provide that future rate increases may not exceed an inflation-indexed amount, plus increases in certain costs beyond the cable operator's control, such as taxes, franchise fees and programming costs. Cost-based adjustments to these capped rates can also be made in the event a cable operator adds or deletes channels or significantly upgrades its system. In addition, new product tiers consisting of services new to the cable system can be created free of rate regulation as long as certain conditions are met, e.g., services may not be moved from existing tiers to the new product tier. The rules also require that charges for cable-related equipment (e.g., converter boxes and remote control devices) and installation be unbundled from the provision of cable service and based upon actual costs plus a reasonable profit. Local franchising authorities and/or the FCC aze empowered to order a reduction of existing rates that exceed the maximum permitted level for either basic and/or CPST services and associated equipment, and refunds can be required. In 1996, the FCC adopted a Social Contract with Time Warner Cable which resolved all of the cable television rate complaints then pending against Time Warner Cable and requires Time Warner Cable to upgrade its domestic cable television systems. The Social Contract was negotiated in accordance with the FCC's authority to consider and adopt "social contracts" as alternarives to other regulatory approaches applicable to cable television rates. Specifically, the Social Contract provides for an estimated $4.7 million plus interest in refunds in the form of bill credits to subscribers of certain designated Time Warner Cable systems, a commitment by Time Warner Cable to establish a lifeline basic service priced at 10% below Time Wamer Cable's benchmark regulated rates with an adjustment to the nonbasic tier to recoup the reduced basic service tier revenue; and a commitment by Time Warner Cable to upgrade its domestic systems by December 31, 2000. Time Wamer Cable is allowed to increase the non-basic service tier by $1.00 per year over the term of the Social Contract. At Time Warner Cable's election, the Social Contract's limitation on non-basic service tier rates would no longcr be effective after Mazch 31, 1999. Court appeals that were filed seelcing review of the FCC decision adopting the Social Contract have all been resolved. An appeal filed by Middletown Township, PA in 1999 remains pending but is limited to the question whether Time Warner Cable owes refunds to subscribers in that 'Township. Carriage ojBroadcast Television Signals. The 1992 Cable Act allows commercial television broadcast stations that are "local" to a cable system to elect every three years either to require the cable system to carry the station, subject to certain exceptions, or to negotiate for "retransmission consent" to carry the starion. Broadcast stations may seek monetary compensation or the carriage of additional programming in return for granring retransmission consent. Local non-commercial television stations aze also given mandatory carriage rights, subject to certain exceptions. Unlike commercial stations, non-commercial stations are not given the option to require negotiarion of retransmission consent. In addition, cable systems must obtain retransmission consent for the carriage of all "distanY' commercial broadcast stations, except for certain "superstations," i.e., commercial satellite-delivered independent stations such as WGN. Time Warner Cable has obtained any necessary retransmission consents from all stations carried, which consents have varying expiration dates. In those cases where the expiration date of particular agreemeats has not been contractually varied from the original schedule set up by the 1992 Act, the next three-year election between mandatory carriage and retransmission consent for local commercial television stations will occur on October 1, 1999. Deletion of Certain Programming. Cable television systems that serve 1,000 or more customers must delete the simultaneous or nonsimultaneous network programming of a distant station upon the appropriate request of a local television station holding local exclusive rights to such programming. FCC regulations also enable television broadcast stations that have obtained exclusive distribution rights for syndicated program- ming in their mazket to require a cable system to delete or "black out" such programming from non-local television stations which are carried by the cable system. I-29 Public and Leased Access Channels. The 1984 Cable Act permits local franchising authorities to require operators to set aside certain channels for public, educational and govemmental access programming. The 1984 Cable Act further requires cable television systems with thirty-six or more activated channels to designate a portion of their channel capacity for commercial leased access by unaffiliated third parties. The 1992 Cable Act requires leased access rates to be set according to a formula determined by the FCC. Ownership. The 1996 Telecommunications Act repealed the 1984 Cable Act's restrictions on local exchange telephone companies (".LECs") from providing video programming directly to customers within their local exchange telephon� sezvice areas. With certain limited exceptions, a LEC may not acquire more than a 10% equity interest in an existing cable system operating within the LEC's service area. The 1996 Telecommunications Act also authorized LECs and others to operate "open video systems" ("OVS") which are not subject to the full array of regulatory obligations imposed on traditional cable systems, although OVS operators can be required to obtain a franchise by a local governmental body and/or to make payments in lieu of cable franchise fees. A number of separate entities have been certified to operate open video systems in areas where the Company operates cable systems, including New York City. The 1996 Telecommunications Act eliminated the FCC rule prohibiting common ownership between a cable system and a national broadcast television network, and the statutory ban covering certain common ownership interests, operation or control between a television station and cable system within the station's Grade B signal coverage area. However, the parallel FCC rule against cable/television station cross-ownership remains in place, subject to the outcome of a pending review by the FCC. Time Warner Cable obtained a temporary waiver from this rule, and has sought a permanent waiver, so that it could continue to own certain Atlanta area cable systems located within the Grade B signal coverage area of television station WTBS. The FCC denied the permanent waiver request, but that denial is presently stayed pending resolution of a petition for reconsideration. This matter will be rendered moot upon consummation of a proposed exchange of cable systems with MediaOne. Finally, the 1992 Cable Act prohibits common ownership, control or interest in cable television systems and MMDS facilities or SMATV systems having overlapping service areas, except in limited circumstances. The 1996 Telecommunications Act exempts cable systems facing "effective competi- don" from the MMDS and SMATV cross-ownership restrictions. The FCC has initiated a rulemaking proceeding in which it asks what restrictions, if any, should be placed on a cable operator's ownership of. a DTH service. This could affect Time Warner, in that TWE has an ownership interest in Primestar, a DTH service. This concern would no longer exist if the proposed sale of Primestar to DirectTV is consummated..See "Cable — Primestar," above. The 1992 Cable Act directed the FCC to adopt so-called subscriber-limit rules, establishing reasonable limits on the number of cable subscribers an operator may reach through systems in which it holds an attributable interest. The FCC has promulgated a rule imposing a limit of 30% of homes passed, but it is currently conducting further rulemaking proceedings in which it may revisit the substance of that rule. Pursuant to the 1992 Cable Act, the FCC has also adopted so-called channel-occupancy rules that, with certain exceptions, preclude a cable television system from devoting more than 40% of its first 75 activated channels to national video programming services in .which the cable system owner has an attributable interest. Time Warner Cable is a party to a federal-court challenge to the validity of both the channel-occupancy rules and the subscriber-limit rules. Pending this challenge, the FCC has voluntarily stayed the effectiveness of the subscriber-limit rules (with the exception of certain reporting requirements) but not the channel-occupancy rules. Other FCC Regulations. Additional FCC regulations relate to a cable system's carriage of local sports programming; privacy of customer information; equipment compatibility; franchise transfers; franchise fees; closed captioning; equal employment opportunity; pole attachments; restrictions on origination and cablecast- ing by cable system operators; application of the rules goveming political broadcasts; customer service; technical standards; home wiring; and limitations on advertising contained in nonbroadcast children's programming. Pursuant to the 1996 Telecommunications Act, the FCC changed the formula for pole attachment fees which will result in substantial increases in payments by cable operators to utilities for pole I-30 attachment rights when telecommunications services are delivered by cabie systems. This new higher rate formula will be phased in beginning in February 2001. Copyright. Cable television systems are subject to federal copyright licensing covering carriage of broadcast signals. In exchange for making semi-annual payments to a federal copyright royalty pool and meeting certain other obligations, cable operators obtain a statutory license to retransmit broadcast signals. The amount of this royalty payment varies, depending on the amount of system revenues from certain sources, the number of distant signals carried, and the location of the cable system with respect to over-the-air television stations. State and Local Regulation. Because a cable television system uses local streets and rights-of-way, cable television systems are subject to local regularion, typically imposed through the franchising process, and certain states have also adopted cable television legislation and regulations. Cable franchises are nonexclusive, granted for fixed terms and usually terminable if the cable operator fails to comply with material provisions. No Time Warner Cable franchise has been terminated due to breach. Franchises usually call for the payment of fees (which are limited under the 1984 Cable Act to 5% of the system's gross revenues from cable service) to the granting authority. The terms and conditions of cable franchises vary materially from jurisdiction to jurisdicrion, and even from city to city within the same state, historically ranging from reasonable to highly restrictive or burdensome. The 1992 Cable Act prohibits exclusive franchises and allows franchising authorities to operate their own multichannel video distribution system without having to obtain a franchise. The 1996 Telecommunications Act provides that local franchising authorities may not condition the grant or renewal of a cable franchise on the provision of telecommunications service or facilities (other than institutional networks) and clarifies that the calculation of franchise fees is to be based solely on revenues derived from the provision of cable services, not revenues derived from telecommunications services. Renewal of Franchises. The 1984 Cable Act established renewal procedures and criteria designed to protect incumbent franchisees against arbitrary denials of renewal. While these formal procedures are not mandatory unless timely invoked by either the cable operator or the franchising authority, they can provide substantial protection to incumbent franchisees. The 1992 Cable Act makes several changes to the renewal process which could make it easier in some cases for a franchising authority to deny renewal. In the renewal process, a franchising authority may seek�to impose new and more onerous requirements, such as upgraded facilities, increased channel capacity or enhanced services, although the municipality must take into account the cost of ineeting such requirements. Time Warner Cable may be required to make significant additional investments in its cable television systems as part of the franchise renewal process. Of Time Wamer Cable's franchises, as of January 1, 1999, approximately 180 franchises serving approximately 580,000 subscribers expire during the period ending December 31, 2001. Although Time Warner Cable has been successful in the past in negotiating new franchise agreements, there can be no .assurance as to the renewal of franchises in the future. The foregoing dces not describe all present and proposed federal, state and local regulations and legislation relating to the cable television industry. Other existing federal regulations, copyright licensing and, in many jurisdictions, state and local franchise requirements, currently are the subject of a variety of judicial proceedings, legislative hearings and administrative and legislative proposals which could change, in varying degrees, the manner in which cable television systems operate. FTC Consent Decree As a result of the TBS Transaction, the Company is subject to a Consent Decree (the "FfC Consent Decree") entered into with the Federal Trade Commission ("FI'C"), certain provisions of which impose limitations on the Company's business conduct with respect to the sale of certain of its cable programming services. These provisions, among other things, prohibit the Company from increasing the pre-TBS Transac- tion pricing ratios which existed between lazge and small distributors in geographic areas also served by Time I-31 Warner Cable. In addition, under the terms of the FTC Consent Decree, Time Warner Cable is required to carry on a significant number of its cable systems a 24hour per day news and information channel that is not owned, controlled by or affiliated with the Company. Compliance with the FTC Consent Decree is not expected to cause an undue financial burden on the Company. New Copyright Legislation In 1998 two important pieces of federal legislation were enacted that will benefit the Company's businesses: The Sonny Bono Copyright Term Extension Act extends the term of copyright protection in the United States by 20 years, and the Digital Millennium Copyright Act ("DMCA") prohibits the circumven- tion of copy protection technologies and establishes rules with respect to the liability of online service providers for copyright infringements when users or subscribers transmit or provide infringing material. I-32 DESCRIPTION OF AGREEMENT WTTH LIBERTY MEDIA CORPORATION The following description summarizes certain provisions of the Company's agreement with Liberty Media Corporation (an af�liate of TCI) and certain of its subsidiaries (collectively, "LMC") that was entered into in connection with the TBS Transaction and the FTC Consent Decree. Such description does not purport to be complete and is subject to, and is qualified in its entirety by reference to, the provisions of the Second Amended and Restated LMC Agreement dated as of September 22, 1995 among the Company, Time Warner Companies, Inc. and LMC (the "LMC Agreement"). Ownership of Time Warner Common Stock Pursuant to the LMC Agreement, immediately following consummation of the TBS Transaction, LMC exchanged the 50.6 million shares of Time Warner common stock, par value $.O1 per shaze ("Time Warner Common Stock"), received by LMC in the TBS Transaction on a one-for-one basis for 50.6 million shares of Series LMCN-V Common Stock. In June 1997, LMC and its affiliates received 6.4 million additional shares of Series LMCN-V Common Stock pursuant to the provisions of an option agreement between the Company and LMC and its affiliates. Each share of Series LMCN-V Common Stock receives the same dividends and otherwise has the same rights as two shares of Time Warner Common Stock except that (a) holders of Series LMCN-V Common Stock are entided to 1/SOth of a vote per share on the election of directors and do not have any other voting rights, except as required by law or with respect to limited matters, including amendments to the terms of the Series LMCN-V Common Stock adverse to such holders, and (b) unlike shares of Time Warner Common Stock, shares of Series LMCN-V Common Stock are not subject to redemption by the Company if necessary to prevent the loss by the Company of any governmental license or franchise. The Series LMCN-V Common Stock is not transferable, except in limited circumstances, and is not listed on any securiries exchange. LMC exchanged its shares of Time Warner Common Stock for Series LMCN-V Common Stock in order to comply with the FTC Consent Decree, which effectively prohibits LMC and its af�liates (including TCI) from owning voting securities of the Company other than securities that have limited voting rights. Each share of Series LMCN-V Common Stock is convertible into two shares of Time Warner Common Stock at any time when such conversion would no longer violate the FTC Consent Decree or have a Prohibited Ei%ct (as defined below), including following a transfer to a third party. Other Agreements Under the LMC Agreement, if the Company takes certain actions that have the effect of (a) making the continued ownership by LMC of the Company's equity securities illegal under any federal or state law, (b) imposing damages or penalties on LMC under any federal or state law as a result of such continued ownership, (c) requiring LMC to divest any such Company equity securities, or (d) requiring LMC to discontinue or divest any business or assets or lose or significantly modify any license under any communica- tions law (each a"Prohibited Effect"), then the Company will be required to compensate LMC for income taxes incurred by it in disposing of all the Company's equity securiries received by LMC in connection with the TBS Transaction and related agreements (whether or not the disposition of all such equity securities is necessary to avoid such Prohibited Effect). The agreements described in the preceding paragraph may have the effect of requiring the Company to pay amounts to LMC in order to engage in (or requiring the Company to refrain from engaging in) activities that LMC would be prohibited under the fedcral communications laws from engaging in. Based on the current businesses of the Company and LMC and based upon the Company's understanding of applicable law, the Company dces not expect these requirements to have a material effect on its business. I-33 DESCRIPTION OF CERTAIN PROVISIONS OF THE TWE PARTNERSHIP AGREEMENT The following description summarizes certain provisions of the TWE Partnership Agreement relating to the ongoing operations of TWE. Such description does not purport to be complete and is subject to, and is qualified in its entirety by reference to, the provisions of the TWE Partnership Agreement. Management and Operations of TWE Partners. Upon the capitalization of TWE in June 1992, certain subsidiaries of the Company became the general partners (the "Class B Partners" or the "Time Wamer General Partners") of TWE and subsidiaries of Itochu Corporation ("ITOCHU") and Toshiba Corporation ("Toshiba") became limited partners of TWE (the "Class A Partners"). A subsidiary of MediaOne (formerly US West) was admitted as a Class A Partner in September 1993. In 1995, Time Wamer acquired the limited partnership interests of Itochu and Toshiba. Consequently, the limited partnership interests in TWE are held by the Class A Partners consisting of MediaOne and whoIly owned subsidiaries of the Company and the general partnership interests in TWE are held by the CIass B Partners consisting of wholly owned subsidiaries of the Company. Board of Representatives. Subject to the authority of the Cable Management Committee (as described below) with respect to the Cable division, the business and afiairs of TWE are managed under the direction of a board of representatives (the "Board of Representatives" or the "Board") that is comprised of representa- tives appointed by subsidiaries of Time Warner (the "Time Warner Representatives") and representatives appointed by MediaOne (the "MediaOne Representatives"). The Time Warner Representatives control all Board decisions except for certain matters including (i) the merger or consolidation of TWE; (ii) the sale or other disposition of assets of TWE generating in excess of 10% of the consolidated revenues of TWE during the previous fiscal year or representing in excess of 10°/0 of the fair market value of the total assets of TWE (in each case, other than in connection with certain joint ventures and "cable asset swaps" as to which the thresholds are greater); (iii) any acquisition by TWE, other than in the ordinary course of business, if the consideration paid by TWE in connection with such acquisition would exceed the greater of (1) $750 million and (2) 10% of the consolidated revenues of TWE for the most recently ended fiscal year of TWE; (iv) the engagement by TWE in any business other than the businesses then being conducted by TWE, as they may evolve from time to time and any business related to such businesses (provided that TWE may not engage in the manufacturing, sale or servicing of hazdware, other than as may be incidental to TWE's businesses); (v) the incurrence by TWE of indebtedness for money borrowed if, after giving effect to such incurrence, the ratio of total indebtedness for money borrowed to cash flow would exceed the greater of (x) 5.00 to 1.00 and (y) .5 over the analogous ratio in the TWE credit agreement as in effect from time to time; (vi) cash distributions other than as provided in the TWE Partnership Agreement; (vii) the dissolution or voluntary bankruptcy of TWE; and (viii) any amendment to the TWE Partnership Agreement, which matters also require the approval of the MediaOne Representatives. The managing general partners, both of which are wholly owned subsidiaries of Time Warner, may take any acrion without the approval or consent of the Board if such acrion may be authorized by the Time Warner Representatives without the approval of the MediaOne Representatives. However, see "Cable Management Committee," below. Cable Management Committee. Subject to obtaining necessary franchise and other approvals, the businesses and operations of the cable television systems ("Cable Systems") of TWE and the TWE-A/N Partnership are govemed by a Cable Management Committee (the "Management Committee"). The Management Committee is comprised of six voting members, three designated by MediaOne and three designated by TWE. Advance/Newhouse has the right to designate a non-voring member to the Management Committee. If MediaOne at any time owns less than 50% of the partnership interest which it owned, directly or indirectly, as of September 15, 1993 or if a"change in control" of MediaOne occurs, MediaOne's right to designate or maintain any members of the Management Committee will terminate. The Cable Systems are managed on a day-to-day basis by Time Warner Cable: The approval of a majority of the members of the Management Committee is required for certain significant transactions relating to the Cable Systems, I-34 including, among other things, the sale, pledge or encumbrance of assets of any Cable System, the acquisition of cable assets, the making of commitments or expenditures relating to any Cable System, in each case subject to agreed upon thresholds, certain decisions with respect to design, architecture and designation of cable systems for upgrade and the adoption of the annual business plan. Day-to-Day Operations. TWE is managed on a day-taday basis by the officers of TWE, and each of TWE's three principal divisions is managed on a day-to-day basis by the officers of such division. The officers of Time Warner are also officers of TWE. Certain Covenants Covenant Not to Compete. For so long as any partner (or affiliate of any partner) owns in excess of 5% of TWE and in the case of any Time Warner General Partner, for one year thereafter, such partner (including its afiiliates) is generally prohibited from competing or owning an interest in the three principal lines of business of TWE — cable, cable programming and filmed entertainment (including the ownership and operation of theme parks) — as such businesses may evolve, subject to certain agreed upon exceptions (including TBS), limited passive investments and inadvertent violations. The covenant not to compete does not prohibit (i) MediaOne from conducting cable and certain regional programming businesses in the 14-state region in which US WEST, Inc. provides telephone service, (ri) any party from engaging in the cable business in a region in which TWE is not then engaging in the cable business, subject to TWE's right of first refusal with respect to such cable business, or (iu) any party from engaging in the telephone or information services business. ITOCHU and Toshiba continue to be bound by and benefit from the non-compete provisions but only as they relate to Japan. Transactions with A�"iliates. Subject to agreed upon exceprions for certain types of arrangements, TWE has agreed not to enter into transacrions with any partner or any of its affiliates other than on an arm's-length basis: Registration Rights Beginning on June 30, 2002 (or as early as June 30, 1999 if certain threshold cash distributions are not made to the Class A Partners), the Class A Partners holding, individually or in the aggregate, at least 10% of the residual equity of T'WE will have the right to request that 'I'WE reconstitute itself as a corporation and register for sale in a public offering an amount of partnership interests held by such Class A Partners determined by an investment banking firm so as to maximize trading liquidity and minimize the initial public offering discount, if any. Upon any such request, the parties will cause an investment banker to determine the price at which the interests sought to be registered could be sold in a public of%ring (the "Appraised Value"). Upon determination of the Appraised Value, TWE may elect either to register such interests or purchase such interests at the Appraised Value, subject to certain adjustments. If TWE elects to register the interests and the proposed public offering price (as detemuned immediately prior to the time the public offering is to be declazed effective) is less than 92.596 of the Appraised Value, TWE will have a second option to purchase such interests immediately prior to the time such public offering would otherwise have been declared effecrive by the Securities and Exchange Commission at the proposed public offering price less underwriting fees and discounts. If TWE exercises its purchase option, it will be required to pay the fees and expenses of the underwriters. Upon exercise of either purchase option, TWE may also elect to purchase the entire partnership interests of the Class A Partners requesting registration at the relevant price, subject to certain adjustments. In addirion to the foregoing, MediaOne will have the right to exercise an additional demand registration right (in which the other Class A Partners would be entided to participate) beginning 18 months following the date on which 'TWE reconstitutes itself as a corporation and registers the sale of securities pursuant to a previously exercised demand registration right. At the request of any Time Warner General Partner, TWE will effect a public ofiering of the partnership interests of the Time Warner General Partners or reconstitute TWE as a corporation and register the shares held by the Time Warner General Partners. In any such case, the Class A Partners will have standard "piggy- back" registration rights. I-35 Upon any reconstitution of TWE into a corporation, each partner will acquire preferred and common equity in the corporation corresponding in both relative value, rate of return and priority to the partnership interests it held prior to such reconstitution, subject to certain adjustments to compensate the partners for the effects of converting their partnership interests into capital Stock. Certain Put Rights of the Class A Partners Change in Control Put. Upon the occurrence of a change in control of Time Warner, at the request of any Class A Partner, TWE will be required to elect either to liquidate TWE within a two-year period or to purchase the interest of such partner at fair market value �(without any minority discount) as determined by investment bankers. A"change in control" of Time Warner shall be,deemed to have occurred: (x) whenever, in any three-year period, a majority of the members of the Board of Directors of the Company elected during such three-year period shall have been so elected against the recommendation of the management of the Company or the Board of Directors shall be deemed to have been elected against the recommendation of such Boaid of Directors of the Company in office immediately prior to such election; provided, however, that for purposes of this clause (x) a member of such Boazd of Directors shall be deemed to have been elected against the recommendation of such Board of Directors if his or her initial election occurs as a result of either an actual or threatened elecrion contest (as such terms are used in Rule 14a-11 of Regulation 14A promuIgated under the Securities Exchange Act of 1934, as amended) or other actual or threatened soIicitation of proxies or consents by or on behalf of a person other than such Board of Directors; or (y) whenever any person shall acquire (whether by merger, consolidation, sale, assignment, lease, transfer or otherwise, in one transaction or any related series of transactions), or otherwise beneficially owns voting securities of the Company that represent in excess of 50% of the voring power of all outstanding voting securities of the Company generally entitled to vote for the election of directors, if such person acquires or publicly announces its intention to initially acquire ten percent or more of such voting securities in a transaction that has not been approved by the management of the Company within 30 days after the date of such acquisirion or public announcement. Assignment of Put Rights, etc. TWE, with the consent of such assignee, may assign to the Company, any general partner or any third party, the obligation to pay the applicable put price in connection with the exercise of a change in control put right by a Class A Partner and the right to receive .the partnership interests in payment therefor. With respect to any of the put rights of the Class A Partners, TWE may pay the applicable put price in cash or Marketable Securities (defined as any debt or. equity securities that are listed on a national securities exchange or quoted on NASDAQ) issued by TWE (or if TWE assigns its obligation to pay the put price to the Company, by the Company). The amount of any Marketable Securities comprising the applicable put price shall be determined based on the mazket price of such securities during the seven months following the closing of such put transaction. Restrictions on Transfer by Time Warner General Partners Time Warner General Panners. Any Time Wamer General Partner is permitted to dispose of any partnership interest (and any Time Warner General Partner and any parent of any Time Warner General Partner may issue or sell equity) at any time so long as, immediately after giving effect thereto, (i) the Company would not own, directly or indirectly, less than (a) 43.75% of the residual equity of TWE, if such disposition occurs prior to the date on which the Class A Partners have received cash distributions of $500 million per $1 billion of investment, and (b) 35% of the residual equity of TWE if such disposition occurs after such date, (ii) no person or entity would own, directly or indirectly, a partnership interest greater than that owned, directly or indirectly, by the Company, and (iii) a subsidiary of the Company would be a managing general partner of TWE. I-36 No other dispositions are permitted, except that the Company may sell its entire partnership interest subject to the Class A Partners' rights of first refusal and "tag-along" rights pursuant to which the Company must provide for the concunent sale of the partnership interests of the Class A Partners so requesting. CURRENCY RATES AND REGULATIONS The Company's foreign operations are subject to the risk of fluctuation in currency exchange rates and to exchange controls. The Company 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 Note 1 "Organization and Summary of Significant Accounting Policies — Foreign Currency" and Note I S"Financial Instruments — Foreign Currency Risk Management" to the consolidated financial statements set forth at pages F-29 and F-56, respectively, herein. For the revenues of international operations, see Note 16 "Segment Information" to the consolidated financial statements set forth on page F-58 herein. EMPLOYEES At December 31, 1998, the Company employed a total of approximately 67,500 persons, including approximately 29,400 persons employed by TWE. I-37 Item 2. Properties Corporate, TBS, Publishing and Music The following table sets forth certain information as of December 31, 1998 with respect to the Company's principal properties (over 250,000 square feet in area) that are used primarily by TBS and the Company's publishing and music divisions or occupied for corporate oflices, all of which the Company considers adequate for its present needs, and a11 of which were substantially used by the Company or were leased to outside tenants: Approximate Square Feet Type of Ownership Location Principai Use Floor Space Expiration Date of Lease New York, New York Executive and administrative 560,000 Leased by the Company. Lease 75 Rockefeller Plaza offices (Corporate and Music) expires in 2014. Rockefeller Center Approximately 94,368 sq. ft. are sublet to outside tenants. New York, New York Time & Life Bldg. Rockefeller Center New York, New York 1290 Ave. of the Americas Atlanta, Georgia One CNN Center Atlanta, Georgia 1050 Techwood Dr. Lebanon, Indiana 121 N. Enterprise Blvd. Mechanicsburg, Pennsylvania 1225 S. Market St. Indianapolis, Indiana 4200 N. Industrial Street Olyphant, Pennsylvania 1400 and 1444 East Lackawanna Avenue Nortorf, Germany Niedernstrasse 3-7 Alsdorf, Germany Max-Planck Strasse 1-9 Terre Haute, Indiana 4025 3rd Parkway Business and editorial offices (Publishing and Corporate) Offices (Music) Executive and administrative offices, studio (TBS) retail, hotel and theatres Offices and studios (TBS) Warehouse space (Publishing) Office and warehouse space ( Publishing) Warehouse space (Publishing) Manufacturing, warehouses, distribution and office space (Music) Manufacturing, distribution and office space (Music) Manufacturing, distribution and office space (Music) Manufacturing and office space (Music) I-38 1,506,000 Leased by the Company. Most leases expire in 2007. Approximately 33,000 sq. ft. are sublet to outside tenants. 273,800 Leased by the Company. Leases expire 2000-2012. Approximately 30,850 sq. ft. are sublet to outside tenants. 1,570,000 Owned by the Company. Approximately 131,140 sq. ft. are sublet to outside tenants. 311,000 Owned and occupied by the Company. 500,450 Leased by the Company. Lease expires in 2006. 358,000 Owned and occupied by the Company. 253,000 Owned and occupied by the Company. 1,012,000 Owned and occupied by the Company. 550,000 Owned and occupied by the Company. 269,000 Owned and occupied by the Company. 269,000 Leased by the Company. Lease expires in 2001. Cable Networks — HBO, Filroed Entertainmeat and Cable The following table sets forth certain information as of December 31, 1998 with respect to principal properties (over 250,000 square feet in area) owned or leased by the Company's Cable Networks — HBO, Filmed Entertainment and cable television businesses, all of which the Company considers adequate for its present needs, and all of which were substantially used by 'TWE: Location New York, New York 1100 and 1114 Avenue of the Americas Burbank, Califomia . The Warner Bros. Studio Baltimore, Maryland White Marsh West Hollywood, California The Warner Hollywood Studio Valencia, California Undeveloped Land PIIACIpfl� USE Business ofiices (HBO) Sound stages, administrative, technical and dressing room structures, screening theaters, machinery and equipment facilities, back lot and pazking lot and other Burbank properties (Filmed Entertainment) Warehouse (Filmed Entertainment) Sound stages, administrative, technical and dressing room structures, screening theaters, machinery and equipment facilities (Filmed Entertainment) Location filming (Filmed Entertainment) Approximate Squsre Feet Floor Space/Acres 335,000 sq. ft. and 241,390 sq. ft. 3,303,000 sq. ft. of improved space on 158 acres(a) Type of Ownership; Expiration Date of l.ease Leased by TWE. Leases expire in 2004 and 2006. Owned by TWE. 387,000 sq. ft. Owned by TWE. 350,000 sq. ft. of improved space on 11 acres 232 acres Owned by TWE. Owned by TWE. (a) Ten acres consist of various pazcels adjoining The Warner Bros. Studio, with mixed commercial, office and residential uses. Item 3. Lega! Proceedings In the matter of Six Flags Fund, Ltd., �x Flags Over Georgia, LLC and George DeRay v. Time Warner Entertainment Company, L.P., Six Flags Entertainment Corporation, Six Flags Theme Parks Inc., and Six Flags Over Georgia, Inc., which has been pending in the Superior Court for Gwinnett County, Georgia and which is described further in the Form 10-K filed by the Company for the year ended December 31, 1997, plaintiffs sought imposition of a constructive trust, compensatory damages in excess of $250 million and unspecified punitive damages for alleged breaches of fiduciary duty, conversion, fraud and conspiracy allegedly committed by the defendants in connection with the management of the Six Flags Over Georgia theme park. On October 22, 1998, following the close of discovery, plaintiffs amended their complaint so as to drop their claim for fraud and to modify their claim for breach of contract. Following trial, on December 18, 1998, the jury returned a verdict in favor of the plaintiffs and awarded the two plaintiffs a total of approximately $197 million in compensatory damages on their claims for breach of fiduciary duty. On December 21, 1998, the same jury awarded plaintiffs an additional $257 million in punitive damages. Defendants moved on February 1, 1999, for judgment notwithstanding the verdict, for a new trial and for the remittur of all or part of the damages awarded by the jury based on defendants' assertion that the trial court committed legal error. Among other grounds, defendants argue that defendants complied with all fiduciary duties as are defined by the operative legal agreement between the parties; that defendants' conduct in the context of arm's length negotiations was not a breach of fiduciary duty as a matter of law; that defendants cannot be held liable for their good-faith business judgments; that as a matter of law the defendants did not have a fiduciary duty to make capital expenditures in amounts that exceeded those that were otherwise contractually agreed to by the I-39 parties; that the Court improperly prevented defendants from introducing relevant and important evidence; and that the Court improperly commented on evidence received during the trial. Defendants' papers also argue that the Court provided a number of erroneous instructions to the jury or, in other cases, failed to provide any instruction to the jury on pertinent legal issues, including the application of law with respect to alleged fiduciary duties in matters specifically addressed by contract. With respect to damages, defendants argue that the evidence presented concerning compensatory damages was unduly speculative and excessive as a matter of law, and that the evidence and applicable law cannot support the award of punitive damages. TWE and its 51% partner in Six Flags retained financial responsibility for this litigation following completion of the sale of the Six Flags companies to Premier Parks, Inc. On September 13, 1995, Francis Ford Coppola, Fred Fuchs and FFC, Inc. ("Coppola") filed a lawsuit in the Superior Court of California, County of Los Angeles against Warner Bros., alleging that Warner Bros. unlawfully interfered with Coppola's efforts to develop with another film studio a previously undeveloped film project based on "Pinocchio." Among other things, Coppola asked that the Court declare that any prior agreement between Coppola and Wamer Bros. to produce the film was void or that it be rescinded. In 1997, the Court granted the plaintiffs' motion to declare that any alleged agreement between Warner Bros. and Coppola was void under the Copyright Act's statute of frauds provision. On June 1, 1998, the case went to trial and on July 2, 1998, the jury found in Coppola's favor with respect to the interference claims and awazded $20 million in compensatory damages; on July 9, 1998, the jury awarded an additional $60 million in punitive damages for these claims. Wamer Bros. subsequently filed motions for judgment notwithstanding the verdict, for a new trial and to set aside the damages awarded, as a result of which, on October 15, 1998, the Court vacated the $60 million punitive damages award. Both sides have taken appeals from the Court's rulings. On February 4, 1999, the Department of Justice served a Civil Investigative Demand ("CID") on various motion picture studios including Warner Bros., calling for the production of certain information and documents about distribution licenses and relationships between the studios and movie theaters. The CID served upon Warner Bros. also calls for responsive information about the operations of New Line. In October 1993, 15 music performers or representatives of deceased performers, on behalf of an alleged similarly-situated class, filed suit in the United States District Court for the Northern District of Georgia against approximately 50 record companies, including four WMG record labels. (Samuel D. Moore, et al. v. American Federation of Television and Radio Artists, et al., No. 93-Civ-2358). Plaintiffs claimed that the recording companies under-reported and under-contributed to the Fund, in violation of ERISA, in breach of contract and fiduciary duty, through fraud and embezzlement, and in violation of RICO, and that the American Federation of Television and Radio Artists ("AFTRA") (their union), and the AFTRA Health and Retirement Fund (the "Fund") had breached their fiduciary duties and acted in violation of ERISA in failing to enforce the recording companies' obligations. Plaintiffs sought substantial, but unquantified, monetary damages, treble damages, attorneys' fees and costs and the imposition of a constructive trust over their master recordings. The Court has dismissed all claims against AFTRA. The Court also consolidated with this action a second, similar lawsuit, commenced by the same plaintifis in the United States District Court for the Southern District of New York. Through various Orders during this litigation, the Court has granted the record company defendants' motion to dismiss the ERISA claims but denied the defendants' motion to dismiss state law claims for breach of contract and fraud and a motion for summary judgment on the RICO claims. The Court has also declined to dismiss the claims against the Fund and the Fund Trustees. On January 20, 1998, the Court denied plaintiffs' motions for class certification of the remaining claims against the record company defendants and against the Fund and Fund Trustees. Accordingly, the case is now limited to the individual remaining claims of the 15 named plaintiffs. By Order dated June 22, 1998, the Court granted plaintiffs' motion to certify its order denying class certification for appeal to the Eleventh Circuit Court of Appeals, and granted plaintiffs' motion for entry of judgment pursuant to Rule 54(b) in favor of the recording company defendants on the ERISA claims. On October 6, 1998, the Eleventh Circuit accepted interlocutory review of the District Court's Order denying class certification and consolidated that appeal with the appeal on the plaintiffs' ERISA claims. On May 30, 1995, a purported class action was filed with the United States District Court for the Central District of California, entitled Digital Distribution Inc. d/b/a Compact Disc Warehouse v. CEMA Distribu- I-40 tion, Sony Music Entertainment, Inc., Wurner Elektra Atlantic Corporation. UNI Distribution Corporation, Benelsmann Music Group, Inc. and PolyGram Group Distribution, Inc., No. 95-3536. The plaintiff, representing a class of direct purchasers of recorded music compact discs ("CDs"), alleged that Warner Elektra Atlantic Corporation ("WEA"), along with five other distributors of CDs, violated the federal antitrust laws by engaging in a conspiracy to fix the prices of CDs, and sought an injunction and treble damages (the "CD Price-Fixing Class Action"). On January 9, 1996, the defendants' motion to dismiss the amended complaint was granted and the acrion was dismissed, with prejudice. Plaintiff appealed the dismissal to the United States Court of Appeals for the Ninth Circuit, No. 96-55264. On July 3, 1997, the United States Court of Appeals for the Ninth Circuit reversed the dismissal of the amended complaint and remanded the case to the District Court, holding that the amended complaint was sufficient to meet the pleading requirements of the Federal Rules and that the action should proceed. On October 29, 1997, the District Court stayed proceedings in the action due to the filing on May 12, 1997 of a Chapter 7 Petition under the U.S. Bankruptcy Code by plaintiff. Snbsequently, the Bankruptcy Court permitted plaintiff to proceed and the stay was lifted. On April 22, 1998, the Judicial Panel on Multidistrict Lirigation consolidated for pretrial purposes various other actions, including Chandu Dani d/b/a Compact Disc Warehouse and Record Revolution v. EMI Music Distribution, Sony Music EntertaiRment, Inc., Warner Elektra Atlantic Corporation, Universal Music and Video Distribution, Benelsmann Music Group, Inc. and Polygram Group Distribution, Inc., No. 97-7226 (C.D. Cal. 1997); Ofiie, inc. d/b/a Chestnut Hill Compact Disc v. EMI Music Distribution, Sony Music Entertainment, Inc., Warner Elektra At/antic Corporation, Universal Music and Yideo Distribu- tion. Benelsmann Music Group, Inc. and PolyGram Group Distribution, Inc., No. 97-8864 (S.D.N.Y. 1997J; Third Street Jazz and Rock Holding Corporation v. EMI Music Distribution, Sony Music Entertainment. Inc.. Warner Elektra Atlantic Corporation, Universal Music and Yideo DistRbution, Bertelsmann Music Group, Inc. and PolyGram Group Distribution, Inc., No. 97-8864 (C.D. Cal. 1997) and Nathan Muchnick, Inc. v. Sony Music Entertainment, Inc., PolyGram Group Distribution, Inc., Bertelsmann Music Group, Inc., Universal Music and Yideo Distribution, Warner Elektra Atlanttc Corporation and EMI Music Distribution, No. 98 Civ. 0612(S.D.N.Y.1998). The consolidated actions are captioned In re Compact Disc Antitrust Litigation. The Court has outlined certain pretrial procedures and discovery is proceeding pursuant to those procedures. On February 17, 1998, a purported class action was commenced in the Circuit Court of Cocke County, Tennessee at Newport, enritled Ottinger & Silvey, et. al., v. EMI Music Distribution, Inc.. Sony Music Entenainment, Inc., Warner Elektra Atlantic Corporation, UNI Distribution Corporation, Bertelsmann Music Group, Inc., and Polygram Group Distribution, Inc. The action is brought on behalf of persons who from January 29, 1993 to the present, purchased CDs indirecdy from the defendants in Alabama, Arizona, California, the District of Columbia, Florida, Kansas; Maine, Michigan, Minnesota, Mississippi, New Mexico, North Carolina, North Dakota, South Dakota, Tennessee, West Virginia and Wisconsin, and alleges that the defendants are engaged in a conspiracy to fix the prices of CDs, in violation of the antitrust, unfair trade practices and consumer protection statutes of each of those jurisdictions. On May 11, 1998, WEA and the other defendants filed a motion to dismiss the complaint for failure to state a cause of action. Plaintiffs have not yet responded to the motion. On April 11, 1997, the Washington and Dallas o$'ices of the Federal Trade Commission notified WEA that they had commenced a preliminary investigation into whether WEA and others may be violating or have violated laws against unfair competition by the adoption, implementation or maintenance of minimum advertised pricing programs. On September 23, 1997, Waraer Communications Inc. was served by the Federal Trade Commission with a subpcena duces tecum calling for the production of documents in connection with a nonpublic investigation into whether the recorded music distribution companies and others may be engaging or may have engaged in unfair methods of competition through the adoption, implementation and mainte- nance of cooperative advertising programs that included minimum advertised price provisions. WEA has produced documents in response to the subpoena. On July 25, 1996, WEA was served with an antitrust civil investigative demand from the Office of the Attorney General of the State of Florida that calls for the production of documents in connection with an investigation to determine whether there is, has been or may be a conspiracy to fix the prices of CDs or I-41 conduct consisting of unfair methods of competition or unfair trade practices in the sale and marketing of CDs. WEA produced documents in compliance with the invesd�ative demand. By letter dated January 8, 1998, WEA was notified by the OSice of the Attorney General of the State of Florida that certain documents that WEA had produced to its office were shared under a confidentiality provision in the Florida statutes with the Office of the Attorney General of the State of Illinois and the Office of the Attomey General of tlae State of New York. Litigation relating to the 1990 merger of Time Inc. and WCI has either been dismissed or has been dormant for years. The litigation is described in previous reports on Form 10-K filed by the Company. A subsidiary of Time Inc. holds a 50% interest in the pazent entity of American Family Publishers ("AFP"). AFP's principal business is direct mail magazine solicitation based on sweepstakes promotions. On February 2, 1998, Florida's Attomey General filed a lawsuit which charged that AFP's mailings were false and deceptive. The publicity surrounding this lawsuit quickly led to additional suits, filed by other attorneys general as well as private plaintiffs. To date, 54 actions have been filed against AFP and other defendants in various state and federal courts; 23 of these actions name as a party AFP's processing and customer service vendor, Time Customer Service Inc., a wholly owned subsidiary of Time Inc. Of the 54 cases, 26 are class actions, and five aze brought by State Attorneys General; 37 cases are in Federal court and the remaining 17 cases are in State court. These actions allege, among other things; that AFP's sweepstakes magazine solicitations misrepresent that the recipient has won the grand prize in AFP's sweepstakes. The actions seek damages, attomey's fees and injuncrive relief. On March 16, 1998, AFP entered into an"assurance of voluntary compliance" with the Attorneys General of 32 states and the District of Columbia. AFP admitted no wrongdoing but agreed to a payment in reimbursement of investigative expenses. Subsequently, AFP entered inio a settlement with the New York Attomey General, AFP admitted no wrongdoing but agreed to contribute towards a special fund created by the New York Attorney General and also agreed to pay investigative costs. On March 29, 1996, Bartholdi Cable f/k/a Liberty Cable Co., Inc, and LVE, LLC filed suit against TWI, TWE, various cable division subsidiaries and Gerald Levin in the Eastem District of New York. The action alleges claims for monopolization; attempted monopolization; conspiracy to monopolize in violation of the antitrust laws; violations of the Lanham Act for purportedly misleading advertising and deceptive trade pracrices. Defendants answered the complaint and filed counterclaims on June 18, 1997, against Bartholdi and certain individuals. The Court has declined motions to dismiss plaintiffs' claims or defendants' counterclaims. On September 25, 1998, defendants filed a motion for summary judgment, which was denied by the Court on November 17, 1998, with leave for resubmission after six months. Discovery is now o�tgoing. Plaintiffs Andrew Parker and Eric DeBrauwere, on behalf of a purported nationwide class, brought this action on June 16, 1998, against defendants TWE and Time Warner Cable in the Eastern District of New York. After defendants filed a motion to dismiss on August 6, 1998, plaindffs filed an amended complaint, which claims violations of the Cable Act's privacy provisions, 47 U.S.C. § 551, related to the alleged disclosure by defendants of personally identifiable information about plaintiffs through sales of customer lists. Plaintiffs also have asserted claims for violation of New York law for deceptive trade practices, negligent misrepresentation and unjust enrichment. The lawsuit seeks damages under the Cable Act, restitution of profits from the sale of such information, interest, costs and attorney's fees. On December 18; 1998, defendants filed a motion to dismiss the Amended Complaint. Item 4. Submission of Matters to a Vote of Security Holders. Not applicable. I-42 EXECtiTIVE OFFICERS OF THE COMPANY Pursuant to General Instruction G(3), the information regarding the Company's executive officers required by Item 401(b) of Regulation S-K is hereby included in Part 1 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, as of March 12, 1999, of such ofiicer. Name Gerald M. Levin . . . . . . . . . . . . . . . . . . . R.E. Turner ....................... Richard D. Parsons ................. Richard J. Bressler . . . . . . . . . . . . . . . . . Peter R. Haje . . . . . . . . . . . . . . . . . . . . . Timothy A. Boggs .................. Andrew J. Kaslow . . . . . . . : . . . . . . . . ... John A. LaBarca ................... Age Office 59 Chairman of the Board and Chief Executive Officer 60 Vice Chairman of the Board 50 President 41 Executive Vice President and Chief Financial Officer 64 Executive Vice President, General Counsel and Secretary 48 Senior Vice President 49 Senior Vice President 56 Senior Vice President and Controller Set forth below are the principal positions held by each of the executive officers named above since March 1, 1994: Mr. Levin . . . . . . . . . . . . . . . . . . . . . . . . . Chairman of the Board of Directors and Chief Executive Officer since January 1993. Mr. Turner . . . . . . . . . . . . . . . . . . . . . . . . Vice Chairman since the consummation of the TBS Transaction in October 1996. Prior to that, he served as Chairman of the Board and President of TBS from 1970. Mr. Parsons . . . . . . . . . . . . . . . . . . . . . . . President since February 1995. Prior to that, he served as Chair- man and Chief Executive Officer of The Dime Savings Bank of New York, FSB from January 1991. Mr. Bressler . . . . . . . . . . . . . . . . . . . . . . . Executive Vice President and Chief Financial Officer since Janu- ary 1998. Prior to that, he served as Senior Vice President and Chief Financial Officer from March 1995; as Senior Vice Presi- dent, Finance from January 1995; and as a Vice President prior to that. Mr. Haje . . . . . . . . . . . . . . . . . . . . . . . . . Executive Vice President and General Counsel since October 1990 and Secretary since May 1993. Mr. Boggs . . . . . . . . . . . . . . . . . . . . . . . . Senior Vice President since November 1992. Mr. Kaslow . . . . . . . . . . . . . . . . . . . . .. . Senior Vice President since January 1999. Prior to that, he served as Senior Vice President, Human Resources at Becton Dickin- son and Company (medical supplies and devices) from April 1996 and prior to that he served as Vice President, Human Resources at Pepsico Inc. (beverages and snack foods), from September 1994; and Vice President of Pepsico's KFC Interna- tional division prior to that. Mr. LaBarca . . . . . . . . . . . . . . . . . . . . . . Senior Vice President and Controller since May 1997. Prior to that, he served as Vice President and Controller from January 1995; Vice President, Director of Internal Audit from May 1993; and Senior Partner at Ernst & Young LLP prior to that. I-43 PART II Item 5. Market For Registrant's Common Equiry and Related Stockholder Matters. The principal market for the Company's Common Stock is the New York Stock Exchange. For quarterly price information with respect to the Company's Common Stock for the two years ended December 31, 1998, see "Quarterly Financial Information" at page F-69 herein, which information is incorporated herein by reference. The approximate number of holders of record of the Company's Common Stock as of February 28, 1999 was 25,000. , For information on the frequency and amount of dividends paid with respect to the Company's Common Stock during the two years, ended December 31, 1998, see "Quarterly Financial Information" at page F-69 herein, which information is incorporated herein by reference. There is no established public trading market for the Company's Series LMCN-V Common Stock, which as of February 28, 1999 was held of record by nine holders. Item 6. Selected Financia! Data. The selected financial information of the Company for the five years ended December 31, 1998 is set forth at pages F-67 and F-68 herein and is incorporated herein by reference. Item 7. Management's Discussion and Analysis oJ Financial Condition and Results of Operations. The information set forth under the caption "Management's Discussion and Analysis" at pages F-2 through F-23 herein is incorporated herein by reference. Item 7A. Quantitative aRd Qualitative Disclosures About Market Risk. The information set forth under the caption "Interest Rate and Foreign Currency Risk Management" at page F-19 herein is incorporated herein by reference. Item 8. Finaneia! Statements and Suppieraentary Data The consolidated financial statements and supplementary data of the Company and the report of independent auditors thereon set forth at pages F-24 through F-64, F-70 through F-77 and F-66 herein are incorporated herein by reference. Quarterly Financial Information set forth at page F-69 herein is incorporated herein by reference. Item 9. Changes In and Disagreemeats with Accountants on Accounting and Finaacial Disclosure. Not Applicable. II-1 PART III Items 10, 11, 12 and 13. Directors and Executive O,�cers of the Registrant; Executive Compensation; Security Ownership oj Certain Beneficia! Owaers and Management; Certain Relationships aad Related Transactions Information called for by PART III (Items 10, 11, 12 and 13) is incorporated by reference from the Company's definitive Proxy Statement to be filed in connection with its 1999 Annual Meeting of Stockholders pursuant to Regulation 14A, except that the information regarding the Company's execurive officers called for by Item 401(b) of Regulation S-K has been included in PART I of this report and the information called for by Items 402(k) and 402(1) of Regulation S-K is not incorporated by reference. III-1 PART IV Item 14. Exhibits, Financia! Statement Schedules, and Reports On Form 8-K (a)(1)-(2) Financial Statements and Schedules: The list of consolidated financial, statements and schedules set forth in the accompanying Index to Consolidated Financial Statements and Other Financial Information at page F-1 herein is incorporated herein by reference. Such consolidated financial statements and schedules are filed as part of this report. 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 report and such Exhibit Index is incorporated herein by reference. Exhibits 10.1 through 10.20 listed on the accompanying Exhibit� Index identify management contracts or compensatory plans or arrangements required to be filed as exhibits to this report, and such listing is incorporated herein by reference. (b) Reports on Form 8-K. (i) The Company filed a Cunent Report on Form 8-K dated November 19, 1998 in which it reported in Item 5 that the Company had declared a two-for-one split of the Company's common stock and set forth restated historical earnings per share data reflecting such stock split. (ii) The Company filed a Current Report on Form 8-K dated December 18, 1998 in which it reported in Item 5 the jury verdict with respect to the litigation enritled Six Flags Over Georgia, Inc., et al, v. Six Flags Fund, Ltd., et al. described on pages I-39 and I-40 herein. IV-1 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. T1ME WARNER INC. By /S/ PETER R. HAJE Peter R. Haje Executive Vice President, General Counsel and Secretary Date: March 26, 1999 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. Signature Title Date /s/ GERALD M. LEVIN Director, Chairman of the Board and (Gerald M. Levin) Chief Executive Officer (principal executive officer) /s/ RICHARD .T. BRESSLER Executive Vice President and Chief (Richard J. Bressler) Financial Officer (principal financial officer) /s/ JOHN A. LABARCA Senior Vice President and Controller (John A. LaBarca) (principal accounting officer) /S/ MERV ADELSON (Merv Adelson) /S/ J. CARTER BACOT (J. Carter Bacot) 1S/ STEPHEN F. BOLLENBACH (Stephen F. Bollenbach) /S/ JOHN C. DANFORTH (John C. Danforth) /S/ BEVERLY SILLS GREENOUGH (Beverly Sills Greenough) /S/ GERALD GREHNWALD (Gerald Greenwald) IV-2 Director Director Director Director Director Director March 26, 1999 March 26, 1999 March 26, 1999 March 26, 1999 March 26, 1999 March 26, 1999 March 26, 1999 March 26, 1999 March 26, 1999 Signature /S/ CARLA A. HILLS (Carla A. Hills) /S/ REUBEN MARK (Reuben Mark) /S/ MICHAEL A. MILES (Michael A. Miles) /S/ RICHARD D. PARSONS (Richard D. Pazsons) /S/ R.E. TURNER (R.E. Turner) /S/ FRANCIS T. VINCENT, JR. (Francis T. Vincent, Jr.) IV-3 Title Director Director Director Director Director Director Date March 26, 1999 March 26, 1999 March 26, 1999 March 26, 1999 March 26, 1999 March 26, 1999 TIME WARNER INC. AND TIME WARNER ENTERTAINMENT COMPANY, LP. INDEX TO CONSOLIDATED FINANCIAL STATEMENTS AND OTHER FINANCIAL INFORMATION Management's Discussion and Analysis of Results of Operations and Financial Condition ................................................... Consolidated Financial Statements: Balance Sheet ........................................................... Statement of Operations . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Statement of Cash Flows . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Statement of Shazeholders' Equity and Partnership Capital . . . . . . . . . . . . . . . . . . . . . . Notes to Consolidated Financial Statements . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Report of Management ...................................................... Report ofIndependent Auditors .............................................. Selected Financial Information . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Quarterly Financial Informarion . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Supplementary Information .................................................. Financial Statement Schedule II-Valuarion and Qualifying Accounts . . . . . . . . . . . . . . . F-1 Page Time Warner TWE F-2 F-24 F-25 F-26 F-27 F-28 F-65. F-66 F-67 F-69 F-70 F-78 F-79 F-92 F-93 F-94 F-95 F-96 F-120 F-121 F-122 F-123 TIME WARNER I1VC. MANAGEMENT'S DISCUSSION AND ANALYSIS OF RESULTS OF OPERATIONS AND FINANCIAL EONDITION Description of Business Time Wamer Inc. ("Time Warner" or the "Company"), together with its consolidated and unconsoli- dated subsidiaries, is the world's largest media and entertainment company. Time Warner's principal business objective is to create and distribute branded information and entertainment copyrights througHout the world. Time Warner classifies its business interests into four fundamental areas: Cable Networks, consisting principally of interests in cable television programming; Publishing, consisting principally of interests in magazine publishing, book publishing and direct mazkering; Entertainment, consisting principally of interests in recorded music and music publishing, filmed entertainment, television production and television broadcast- ing; and Cable, consisting principally of interests in cable television systems. A majority of Time Warner's interests in filmed entertainment, television production, television broadcasting and cable television systems, and a portion of its interests in cable television programming are held through Time Warner Entertainment Company, L.P. ("TWE"). Time Warner owns general and limited partnership interests in TWE consisting of 74.49% of the pro rata priority capital ("Series A Capital") and residual equity capital ("Residual Capital"), and 100% of the senior priority capital ("Senior Capital") and junior priority capital ("Series B Capital"). The remaining 25.51% limited partnership interests in the Series A Capital and Residual Capital of TWE are held by . a subsidiary of MediaOne Group, Inc. ("MediaOne"), formerly U S WEST, Inc. Time Warner does not consolidate TWE and certain related companies (the "Entertainment Group") for financial reporting purposes because of certain limited partner- ship approval rights related to TWE's interest in certain cable television systems. Overview Time Warner and the Entertainment Group demonstrated strong financial performances in 1998, as measured by the operating performance of their businesses and the improved strength of their combined financial condition, as more fully described herein. This performance was driven primarily by solid business fundamentals and a disciplined financial focus on cost management and controlling capital spending. Use of EBITA ' Time Wamer evaluates operating performance based on several factors, of which the primary financial measure is operating income before noncash amortization of intangible assets ("EBITA"). Consistent with management's financial focus on controlling capital spending, EBITA measures operating performance after charges for depreciation. In addition, EBITA eliminates the uneven effect across all business segments of considerable amounts of noncash amortization of intangible assets recognized in business combinations accounted for by the purchase method, including the $14 billion acquisition of Warner Communications Inc. in 1989, the $6.2 billion acquisition of Turner Broadcasting System, Inc. ("TBS") in 1996 and the $2.3 billion of cable acquisitions in 1996 and 1995. The exclusion of noncash amortization charges also is consistent with management's belief that Time Warner's intangible assets, such as cable television and sports franchises, music catalogues and copyrights, film and television libraries and the goodwill associated with its brands, generally are increasing in value and importance to Time Warner's business objective of creating, extending and distributing recognizable brands and copyrights throughout the world. As such, the following comparative discussion of the results of operations of Time Warner and the Entertainment Group includes, among other factors, an analysis of changes in business segment EBITA. However, EBITA should be considered in addition to, not as a subsritute for, operating income, net income and other measures of financial performance reported in accordance with generally accepted accounting principles. F-2 TIME WARNER INC. MANAGEMENT'S DISCUSSION AND ANALYSIS OF RESULTS OF OPERATIONS AND FINANCIAL CONDTTION —(Continued) Transactions Affecting Comparability of Results of Operations As more fully described herein, the comparability of Time Warner's and the Entertainment Group's operating results has been affected by certain significant transactions and nonrecurring items in each period. For 1998, these significant transactions related to Time Warner's cable business and included (i) the transfer of cable television systems (or interests therein) serving approximately 650,000 subscribers that were formerly owned by subsidiaries of Time Warner to the TWE-Advance/Newhouse Partnership ("TWE-A/N"), subject to approximately $1 billion of debt, in exchange for common and preferred partnership interests in TWE-A/N, as well as certain related transactions (collectively, the "TWE-A/N Transfers"), (ii) the transfer of TWE's and TWE-A/N's direct broadcast satellite operations and related assets to Primestar, Inc. ("Primestar"), a separate holding company (the "Primestar Roll-up Transaction"), (iii) the reorganization of Time Warner Cable's business telephony operations into a separate entity named Time Warner Telecom LLC (the "Time Wamer Telecom Reorganization") and (iv) the formation of a joint venture to operate and expand Time Warner Cable's and MediaOne's existing high-speed online businesses (the "Road Runner Joint Venture" and collectively, the "1998 Cable Transactions"). In addition, there were a number of other significant, nonrecurring items recognized in 1998 and 1997, consisting of (i) net pretax gains in the amount of approximately $108 million in 1998 and $212 million in 1997 relating to the sale or exchange of various cable television systems by Time Warner and TWE, (ii) a pretax gain of approximately $250 million in 1997 relating to TWE's sale of its interest in E! Entertainment Television, Inc. ("E! Entertainment"), (iii) a pretax gain of $200 million in 1997 relating to Time Warner's disposal of its interest in Hasbro, Inc. ("Hasbro"), (iv) a charge of approximately $210 million in 1998 principally to reduce TWE's carrying value of its interest in Primestar, (v) an increase of $234 million in Time Warner's 1998 preferred dividend requirements relating to the premium paid in connection with its redemption of Series M exchangeable preferred stock ("Series M Preferred Stock") and (vi) an extraordinary loss of $55 million in 1997 on the rerirement of debt. In order to meaningfully assess underlying operating trends, management believes that the results of operations for 1998 and 1997 should be analyzed after excluding the effects of these significant nonrecurring items. As such, the following discussion and analysis focuses on amounts and trends adjusted to exclude the impact of these unusual items. However, unusual items may occur in any period. Accordingly, investors and other financial statement users individually,should consider the types of events and transactions for which adjustments have been made. The comparability of Time Wamer's 1997 and 1996 operating results also was affected by certain significant transactions, consisting of (i) Time Warner's October 1996 acquisition of TBS (the "TBS Transaction"), (ii) Time Warner's use of approximately $1.55 billion of net proceeds from the issuance of Series M Preferred Stock in April 1996 to reduce outstanding indebtedness and (rii) certain other debt refinancings during the year (collectively, the "1996 Time Warner Transacrions"). Accordingly, the following discussion of operating results for those periods is supplemented, where appropriate, by pro forma financial information that gives effect to the 1996 Time Warner Transactions as if they had occurred at the beginning of 1996. 1"his pro forma informarion is presented for informational purposes only and is not necessarily indicative of the operating results that would have occutred had the transactions actually occurred at the beginning of that period, nor is it necessarily indicative of future operating results. Finally, per common share amounts for prior years have been restated to give effect to a two-for-one common stock split that occurred on December 15, 1998. F-3 TIME WARNER INC. MANAGEMENT'S DISCUSSION AND ANALYSIS OF RESULTS OF OPERATIONS AND FINANCIAL CONDITION —(Continued) RESULTS OF OPERATIONS 1998 vs. 1997 EBITA and operating income in 1998 and 1997 are as follows: Time Warner.• Publishing .............................................. Music................................................. Cable Networks-TBS ...................... ........... Filmed Entertainment-TBS . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Cable�'� ................................................ Intersegment elimination .................................. Total.................................................. Years Ended December 31, EBITA Operating Income 1998 1997 1998 1997 (miilions) $ 607 493 706 192 325 �2�) $2,296 $ 529 467 573 200 427 (13) $2,183 $ 569 213 506 110 125 �2�) $1,496 $ 481 166 374 113 150 (13) $1,271 Entenainment Group: Filmed Entertainment-Warner Bros . . . . . . . . . . . . . . . . . . . . . . . . . $ 503 $ 404 $ 374 $ 281 Broadcasting-The WB Network ............................ (93) (8�) (96) (88) Cable Networks-HBO . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 454 391 454 391 Cable�Z� ................................................ 1,369 1,184 992 877 Total .................................................. $2,233 $1,891 $1,724 $1,461 (I) lncludes net pretax gdins of approximately $18 million in 1998 and $12 million in 1997 related to the sale or exchange of certain cable television systems. (2) Includes net pretax gains of approximately $90 million in 1998 and $200 million in 1997 related to the sale or exchange of certain cable television systems. Time Warner had revenues of $14.582 billion and net income of $168 million ($.31 loss per common share after prefeaed dividend requirements) in 1998, compared to revenues of $13.294 billion, income of $301 million before an extraordinary loss on the retirement of debt ($.O1 loss per common share after preferred dividend requirements) and net income of $246 million ($.06 loss per common share after preferred dividend requirements) in 1997. Time Warner's equity in the pretax income of the Entertainment Group was $356 million in 1998, compared to $686 million in 1997. As previously described, the comparability of Time Warner's and the Entertainment Group's operating results for 1998 and 1997 has been at%cted by certain significant nonrecurring items recognized in each period, consisting of gains and losses relating to the sale or exchange of cable television systems and other investment-related activity. These nonrecurring items amounted to approximately $100 million of net pretax losses in 1998, compared to approximately $660 million of net pretax gains in 1997. In addition, preferred dividend requirements for 1998 included a$234 million one-time increase relating to the premium paid in connection with Time Warner's redemption of its Series M Preferred Stock. Lastly, 1997 included a$55 million extraordinary loss on the retirement of debt. The aggregate net effect of these significant, nonrecurring items was a decrease in income per common share of $.25 per common share in 1998, compared to an increase of $.27 per common share in 1997. Time Warner's net income decreased to $168 million in 1998, compared to net income of $246 million in 1997. However, excluding the significant effect of the nonrecurring items referred to above, net income F-4 TIME WARNER INC. MANAGEMENI"S DLSCUSSION AND ANALYSIS OF RESULTS OF OPERATIONS AND FINANCIAL CONDITION —(Continued) increased by $300 million to $236 million in 1998, compared to a net loss of $64 million in 1997. As discussed more fully below, this improvement principally resulted from an overall increase in Time Warner's business segment operating income, an increase in income from its equity in the pretax income of the Entertainment Group and lower interest expense associated with Time Warner's debt reduction efforts and the TWE-A/N Transfers, offset in part by higher losses from. certain investments accounted for under the equity method of accounting and lower gains on foreign exchange contracts. Similarly, excluding the effect of these nonrecur- ring items, normalized net loss per common share was $.06 in 1998, compared to a normalized net loss per common share of $.33 in 1997. The Entertainment Group had revenues of $12.256 billion and net income of $331 million in 1998, compared to revenues of $11.328 billion, income of $642 million before an extraordinary loss on the retirement of debt and net income of $619 million in 1997. Similarly, excluding the portion of the nonrecurring items referred to above that was recognized by the Entertainment Group, net income increased by $229 million to $465 million in 1998, compared to $236 million in 1997. As discussed more fully below, this improvement principally resulted from an overall increase in the Entertainment Group's business segment operating income (including the positive effect of the TWE-A/N Transfers), offset in part by an increase in interest expense associated with the TWE-A/N Transfers and higher losses from certain investments accounted for under the equity method of accounting. The relationship between income before income taxes and income tax expense of Time Warner is principally affected by the amortization of goodwill and certain other financial statement expenses that are not deductible for income tax purposes. Income tax expense of Time Warner includes all income taxes related to its allocable shaze of partnership income and its equity in the income tax expense of corporate subsidiaries of the Entertainment Group. TIME WARNER Publishing. Revenues increased to $4.496 billion, compared to $4Z90 billion in 1997, EBITA increased to $607 million from $529 million. Operating income iacreased to $569 million from $481 million. Revenues benefited primarily from significant increases in magazine advertising revenues, as well as increases in magazine circulation revenues. The increase in advertising revenues was principally due to a strong overall advertising market for most of the division's magazines, primarily led by People, Time, Entertainment Weekly, Fortune and In Style. The increase in circulation revenues was principally due to higher subscription and newsstand revenues, primarily led by the same magazines. EBITA and operating income increased principally as a result of the revenue gains, cost savings and one-rime gains on the sale of certain assets, offset in part by lower results from direct markering operations. Music. Revenues increased to $4.025 billion, compared to $3.691 billion in 1997. EBITA increased to $493 million from $467 million. Operating income increased to $213 million fmm $166 million. Revenues benefited from an increase in domestic and international recorded music sales principally relating to higher compact disc sales of a broad range of popular releases from new and established artists and movie soundtracks, as well as lower returns of product. At the end of December 1998, the Music division had a domestic market share of 19.896, as measured by SoundScan. EBITA and operating income increased principally as a result of the revenue gains and cost savings, offset in part by lower results from direct marketing operations, higher artist costs and the absence of certain one-time gains recognized in 1997. Cable Networks-TBS. Revenues increased to $3.325 billion, compared to $2.900 billion in 1997. EBITA increased to $706 million from $573 million. Operating income increased to $506 million from $374 million. Revenues benefited from an increase in subscription and advertising revenues. The increase in subscription revenues principally related to the conversion of TBS Superstation from an advertiser-supported broadcast superstation to a copyright-paid, cable television service, which allows TBS Superstation to charge cable F-5 TIME WARNER INC. MANAGEMENT'S DISCUSSION AND ANALYSIS OF RESULTS OF OPERATIONS AND FINANCIAL CONDITION —(Continued) operators for the right to carry its cable television programming. Subscription revenues also increased as a result of an increase in subscriptions, primarily at CNN, CNN Internarional, TNT/Cartoon Europe and Turner Classic Movies, and higher rates. The increase in advertising revenues was principally due to a strong overall advertising market for most of the division's networks, including TNT, Cartoon Network, TNT/ Cartoon Europe, CNN and CNN Headline News. EBITA and operating income increased principally as a result of the revenue gains and lower programming costs at TNT, offset in part by higher programming costs at CNN and losses associated with the Goodwill. Games. Filmed Entertainmenr-TBS. Revenues increased to $1.917 billion, compared to $1.531 billion in 1997. EBITA decreased to $192 million from $200 million. Operating income decreased to $110 million from $113 million. Revenues benefited from a significant increase in syndication sales resulting from the renewal by existing television station customers of second-cycle broadcasting rights for Seinfeld, as well as an increase in worldwide theatrical and home video revenues at New Line Cinema. Despite the revenue increase, EBITA and operating income decreased principaily as a result of film write-offs relating to disappointing results for theatrical releases of Castle Rock Entertainment in the first half of 1998. � Cable. Revenues decreased to $964 million, .compazed to $997 million in 1997. EBI7A decreased to $325 million from $427 million. Operating income decreased to $125 million from $150 million. The Cable division's 1998 operating results were negatively affected by the aggregate net impact of the deconsolidation of certain of its operations in connection with the 1998 Cable Transactions. Excluding the effect of the 1998 Cable Transacrions, revenues increased principally as a result of an increase in basic cable subscribers, increases in regulated cable rates and an increase in advertising revenues. Similarly excluding the effect of the 1998 Cable Transactions, EBITA and operating income increased principally as a result of the revenue gains and approximately $6 million of higher, net pretax gains relating to the sale or exchange of certain cable television systems, offset in part by higher depreciation related to capital spending. Interest and Other,�Net. Interest and other, net, increased to $1.180 billion in 1998, compared to $1.044 billion in 1997. Interest expense decreased to $891 million, compazed to $1.049 billion, principally due to lower average debt levels associated with the Company's debt reduction efforts and the TWE-A/N Transfers. There was other expense, net, of $289 million in 1998 compared to other income, net of $5 million in 1997, primarily due to lower investment-related income, as well as lower gains on foreign exchange contracts and higher losses associated with the Company's asset securitizarion program. 1"he significant decrease in investment-related income principally resulted from the absence of a$200 million pretax gain recognized in 1997 in connection with the disposal of Time Warner's interest in Hasbro and higher losses in 1998 from certain investments accounted for under the equity method of accounring. ENTERTAINMENT GROUP Filmed Entertainment-Warner Bros. Revenues increased to $6.061 billion, compared to $5.472 billion in 1997. EBITA increased to $503 million from $404 million. Operating income increased to $374 million from $281 million. Revenues benefited from a significant increase in licensing fees from television production and distribution operations, principally relating to the initial off-network domestic syndication availability of Friends and the initial off-network basic cable availability of ER, as well as an increase in revenues from consumer products licensing operations. EBITA and operating income benefited principally from the revenue gains and cost savings, offset in part by lower international syndication sales of library product and lower results from theatrical releases. In addition, EBITA and operating income for each period included certain one-time gains on the sale of assets that were comparable in amount and therefore, did not have any significant effect on operating trends. Broadcasting-The WB Network. Revenues increased to $260 million, compared to $136 million in 1997. EBITA decreased to a loss of $93 million from a loss of $88 million. Operating losses increased to $96 million F-6 TIME WARNER INC. MANAGEMENT'S DISCUSSION AND ANALYSIS OF RFSULTS OF OPERATIONS AND FINANCIAL CONDITION —(Continued) from $88 million. Revenues increased as a result of higher advertising sales relating to improved television ratings and the addition of a fourth night of prime-time programming in January 1998 and a fifth night in September 1998. Despite the revenue increase, operaring losses increased because of a lower allocation of losses to a minority partner in the network. However, excluding this minority interest effect, operating losses improved principally as a result of the revenue gains, which outweighed higher programming costs associated with the expanded programming schedule. Cable Networks-HBO. Revenues increased to $2.052 billion, compared to $1.923 billion in 1997. EBITA and operating income increased to $454 million from $391 million. Revenues benefited primarily from an increase in subscriptions to 34.6 million from 33.6 million at the end of 1997. EBITA and operating income improved principally as a result of the revenue gains and, to a lesser extent, cost savings and higher income from Comedy Central, a 509o-owned equity investee. Cable. Revenues increased to $4.378 billion, compared to $4.243 billion in 1997. EBITA increased to $1.369 billion from $1.184 billion. Operating income increased to $992 million from $877 million. The Cable division's 1998 operating results were positively af%cted by the aggregate net impact of the 1998 Cable Transactions. Excluding the effect of the 1998 Cable Transactions, revenues increased principally as a result of an increase in basic cable subscribers, increases in regulated cable rates and an increase in advertising revenues. Similarly excluding the effect of the 1998 Cable Transactions, EBITA and operating income increased principally as a result of the revenue gains, offset in part by higher depreciation related to capital spending and approximately $110 million of lower, net pretax gains relating to the sale or exchange of certain cable television systems. As of December 31, 1998, including the cable operations of TWE-A/N and TWI Cable Inc. ("TWI Cable"), there were 12.6 million subscribers under the management of TWE's Cable division, as compared to 12.0 million subscribers at the end of 1997. The number of subscribers at the end of 1997 excludes all direct broadcast satellite subscribers that were transferred to Primestar in 1998 in connection with the Primestar Roll-up Transaction. Interest and Other, Net. Interest and other, net, increased� to $965 million in 1998, compared to $357 million in 1997. Interest expense increased to $566 million, compared to $494 million in 1997, principally due to higher average debt levels associated with the TWE-A/N Transfers. There was other expense, net, of $399 million in 1998, compared to other income, net, of $137 million in 1997, .primarily due to lower investment- related income, as well as higher losses associated with TWE's asset securitization program. The significant decrease in investment-related income principally resulted from the absence of an approximate $250 million pretax gain recognized in 1997 in connection with the sale of an interest in E! Entertainment, the inclusion of an approximate $210 million chazge recorded in 1998 principally to reduce the carrying value of an interest in Primestar and higher losses in 1998 from certain investments accounted for under the equity method of accounting. F-7 TIME WARNER INC. MANAGEMENT'S DISCUSSION AND ANALYSIS OF RESULTS OF OPERATIONS AND FINANCIAL CONDITION —(Continued) 1997 vs. 1996 , EBITA and operating income in 1997 and 1996 are as follows: Time Warner.• Publishing ......................... Music............................. Cable Networks-TBS . . . . . . . . . . . . . . . . Filmed Entertainment-TBS . . . . . . . . . . . Cable�� ........................... Intersegment elimination . . . . . . . . . . . . . Total.............................. Years Ended December 31, EBITA Operating Income Historical Pro Forma Historical Historical Pro Forma Historical 1997 1996 1996 1997 1996 1996 (millions) $ 529 467 573 200 427 (13) $2,183 $ 464 653 472 (116) 353 (10) $1,816 $ 464 653 142 30 353 5 $1,647 $ 481 166 374 113 150 (13) $1,271 $ 418 361 297 (202) 75 (10) $ 939 $ 418 361 99 8 75 5 $ 966 Entertainment Group: Filmed Entertainment Warner Bros. ... $ 404 $ 379 $ 379 $ 281 $ 254 $ 254 Broadcasring-The WB Network . . . . . . . (88) (98) (98) (88) (98) (98) Cable Networks-HBO . . . . . . . . . . . . . . . 391 328 328 391 328 328 Cable�� ........................... 1,184 917 917 877 606 606 'Total .............................. $1,891 $1,526 $1,526 $1,461 $1,090 $1,090 (1) Includes net pretax gains in 1997 of approximately $12 million for Time Warner and $200 million for the Entcrtainment Group related to the sale or exchange of certain cable television systems. Time Warner had revenues of $13.294 billion, income of $301 million before an extraordinary loss on the retirement of debt ($.01 loss per common share after preferred dividend requirements) and net income of $246 million ($.06 loss per common share after preferred dividend requirements) in 1997, compared to revenues of $10.064 billion, a loss of $156 million before an extraordinary loss on the retirement of debt ($:48 per common share after preferred dividend requirements) and a net loss of $191 million ($.52 per common share after preferred dividend requirements) in 1996. Time Warner's equity in the pretax income of the Entertainment Group was $686 million in 1997, compared to $290 million in 1996. Time Wamer's historical results of operations include the operating results of TBS from October 10, 1996. On a pro forma basis, giving effect to the 1996 Time Wamer Transactions as if each of such transactions had occurred at the beginning of 1996, Time Wamer would have reported for the year ended December 31, 1996, revenues of $12.799 billion, depreciation expense of $368 million, EBITA of $1.816 billion, operating income of $939 million, equity in the pretax income of the Entertainment Group of $290 million, a loss before extraordinary item of $282 million ($.52 per common share) and a net loss of $317 million ($.55 per common share). No pro forma financial information has been presented for Time Warner for the year ended December 31, 1997 because the 1996 Time Warner Transactions are already reflected in the historical financial statements of Time Warner. As previously described, the comparability of Time Warner's and the Entertainment Group's historical operating results for 1997 and pro forma results for 1996 has been affected further by certain significant nonrecurring items recognized in 1997, consisting of net pretax gains relating to the sale or exchange of cable F-8 TIME WARNER INC. MANAGEMENT'S DISCUSSION AND ANALYSIS OF RESULTS OF OPERATIONS AND FINANCIAL CONDITION —(Continued) television systems and other investment-related activity. These nonrecurring items amounted to approximately $660 million of net pretax gains in 1997. In addition, net income (loss) in each period included extraordinary losses on the retirement of debt of $55 million in 1997 and $35 miilion in 1996. The aggregate net effect of these significant, nonrecurring items was an increase in income per common share of $.27 in 1997, compared to a decrease of $.03 per common share in 1996. Time Warner's operating results improved from a pro forma net loss of $317 million in 1996 to net income of $246 million in 1997. Excluding the significant efi'ect of the nonrecurring items referred to above, Time Warner's net loss improved by $218 million to a net loss of $64 million in 1997, compared to a net loss of $282 million on a pro forma basis in 1996. As discussed more fully below, this improvement principally resulted from an overall increase in Time Warner's EBITA and operating income and an increase in income from its equity in the pretax income of the Entertainment Group. Similarly, excluding the effect of these nonrecurring items, normalized net loss per common share was $.33 in 1997, compared to a normalized net loss per common share of $.52 on a pro forma basis in 1996. On a historical basis, these underlying operating trends were mitigated by an overall increase in interest expense principally relating to the assumption of approximately $2.8 billion of debt in the TBS Transaction, and an increase in noncash amortization of intangible assets, also relating to the TBS Transaction. On a historical basis, after preferred dividend requirements that increased by $62 million due to the April 1996 issuance of Series M Preferred Stock, Time Warner's net loss applicable to common shares improved to $73 million for the year ended December 31, 1997, compared to $448 million for the year ended December 31, 1996. This improvement, as well as the dilutive effect from issuing 359.6 million equivalent shares of common stock in connection with the TBS Transaction, resulted in a net loss per common share of $.06 for the year ended December 31, 1997, compared to a$.52 net loss per common share for the year ended December 31, 1996. On a historical basis, the Entertainment Group had revenues of $11.328 billion, income of $642 million before an extraordinary loss on the retirement of debt and net income of $619 million in 1997, compared to revenues of $10.861 billion and net income of $220 million in 1996. Similarly, excluding the portion of the nonrecurring items referred to above that was recognized by the Entertainment Group, net income increased by $16 million to $236 million in 1997, compared to $220 million in 1996. As discussed more fully below, this improvement principally resulted from an overall increase in EBITA and operating income generated by the Entertainment Group's business segments, ofiset in part by an increase in minority interest expense related to TWE-A/N. The relationship between income before income taxes and income tax expense of Time Warner is principally affected by the amortization of goodwill and certain other financial statement expenses that are not deductible for income tax purposes. Income tax expense of Time Warner includes all income taxes related to its allocable share of partnership income and its equity in the income tax expense of corporate subsidiaries of the Entertainment Group. TIME WARNER Publishing. Revenues increased to $4.290 billion, compared to $4.117 billion in 1996. EBITA increased to $529 million from $464 million. Operating income increased to $481 million from $418 million. Excluding the effect of operations that were either recently sold or acquired, revenues benefited from a significant increase in magazine advertising revenues, as well as increases in circulation and direct marketing revenues. Contributing to the revenue gains were increases achieved by People, Sports Illustrated, Time, Entertain- ment Weekly. In Style and direct marketer Book-of-the-Month Club. EBITA and operating income increased principally as a result of the revenue gains and, to a lesser extent, continued cost savings. F-9 TIME WAitNER INC. MANAGEMENT'S DISCUSSION AND ANALYSIS OF RESULTS OF OPERATIONS AND FINANCIAL CONDITION —(Continued) Music. Revenues decreased to $3.691 billion, compared to $3.949 billion in 1996. EBITA decreased to $467 million from $653 million. Operating income decreased to $166 million from $361 million. Despite the Music division having a domestic market share for the year of 20% as measured by SoundScan, the decline in revenues principally related to softness in the overezpanded U.S. retail marketplace, artist delays affecting the timing of releases of new product and a decline in international recorded music sales. EBITA and operaring income decreased principally as a result of the decline in revenues and lower results from direct marketing activities, offset in pazt by certain one-time gains. Cable Networks-TBS. Cable Networks results reflect the acquisition of TBS effective in October 1996. Such operating results are not comparable to the prior year and, accordingly, are discussed on a pro forma basis. Revenues increased to $2.9U0 billion, compared to $2.477 billion on a pro forma basis in 1996. EBITA increased to $573 million from $472 million. Operating income increased to $374 million from $297 million. Revenues benefited from increases in advertising and subscription revenues. Advertising revenues increased due to a strong overall advertising market for the division's major branded networks, including TNT, TBS Superstation, CNN and Cartoon Network. Subscription revenues increased as a result of higher rates and an increase in subscriptions, primarily at T'NT, CNN, Cartoon Network and Turner Classic Movies. EBITA and operaring income increased principally as a result of the revenue gains, offset in part by start-up costs for new networks, including the sports news network CNN/SI and the Spanish-language news network CNN en Espanol. Filmed Entertainment-TBS. Filmed Entertainment results reflect the acquisition of TBS effective in October 1996. Such operating results are not comparable to the prior year and, accordingly, are discussed on a pro forma basis. Revenues increased to $1.531 billion, compared to $1.458 billion on a pro forma .basis in 1996. EBITA increased to $200 million from a loss of $116 million. Operating income increased to $113 million from a loss of $202 million. Revenues benefited from increases in worldwide theatrical, home video and television distribution revenues. EBITA and operating income increased principally as a result of the revenue gains, merger-related cost savings and the absence of approximately $200 million of write-offs recorded in 1996 that related to disappointing results for theatrical releases. Cable. Revenues increased to $997 million, compared to $909 million in 1996. EBITA increased to $427 million from $353 million. Operating income increased to $150 million from $75 million. Revenues benefited from an increase in basic cable subscribers, increases in regulated cable rates and an increase in advertising and pay-per-view revenues. EBITA and operating income increased principally as a result of the revenue gains, as well as gains of approximately $12 million recognized in 1997 in connection with the sale of certain investments. Interest and Other, Net. Interest and other, net, decreased to $1.044 billion in 1997, compared to $1.174 billion in 1996. Interest expense increased to $1.049 billion, compared to $968 million, principally due to the assumption of approximately $2.8 billion of debt in the TBS Transaction. There was other income, net, of $5 million in 1997 compared to other expense, net, of $206 million in 1996, principally because of the recognition of a$200 million pretax gain in 1997 in connection with the redemption of certain mandatorily redeemable preferred securities and the related disposal of Time Warner's interest in Hasbro and lower losses from the reduction in carrying value of certain investments, offset in part by costs associated with the Company's asset securitization program. F-10 TIME WARNER INC. MANAGEMENT'S DISCLPSSION AND ANALYSIS OF RESULTS OF OPERATIONS AND FINANCIAL CONDITION —(Cootinued) ENTERTAINMENT GROUP Filmed Entertainment-Warner Bros. Revenues decreased to $5.472 billion, compared to $5.648 billion in 1996. EBITA increased to $404 million from $379 million. Operating income increased to $281 million from $254 million. Revenues decreased principally as a result of lower worldwide theatrical and home video revenues, offset in part by increases in worldwide television distribution revenues. EBITA and operating income increased principally as a result of high-margin sales of library product that conhibuted to the strong performance of worldwide television distiriburion operations, cost savings and certain one-time gains, offset in part by higher depreciarion principally relating to the expansion of theme parks and consumer products operations. Broadcasting-The WB Network. Revenues increased to $136 million, compared to $87 million in 1996. EBITA and operating losses improved to a loss of $88 million from a loss of $98 million. The increase in revenues primarily resulted from the expansion of programming in September 1996 to three nights of prime- rime scheduling and the expansion of Kids' WB!, the network's animated programming lineup on Saturday mornings and weekdays. The 1997 operating loss improved principally as a result of the revenue gains and the ef%ct of an increase in a limited partner's interest in the network that occurred in early 1997. Cable Networks-HBO. Revenues increased to $1.923 billion, compared to $1.763 billion in 1996. EBITA and operating income increased to $391 million from $328 million. Revenues benefited primarily from an increase in subscriptions to 33.6 million from 32.4 million at the end of 1996. EBITA and operating income improved principally as a result of the revenue gains and, to a lesser extent, cost savings. Cable. Revenues increased to $4.243 billion, compared to $3.851 billion in 1996. EBITA increased to $1.184 billion from $917 million. Operati.ng income increased to $877 million from $606 million. Revenues benefited from an increase in basic cable and Primestar-related, direct broadcast satellite subscribers, increases in regulated cable rates and an increase in advertising and pay-per-view revenues. EBTTA and operating income increased principally as a result of the revenue gains, as well as net gains of approximately $200 million recognized in 1997 in connection with the sale or exchange of certain cable systems. The increases in EBITA and operating income were partially offset by higher depreciation related to capital spending. As of December 31, 1997, including Primestar-related, direct broadcast satellite subscribers and the cable operations of TWE-A/N and TWI Cable, there were 12.6 million subscribers under the management of TWE's Cable division, as compared to 123 million subscribers at the end of 1996. Interest and Other, Net. Interest and other, net, decreased to $357 million in 1997, compared to $524 million in 1996. Interest expense increased to $494 million, compared to $478 million in 1996. There was other income, net, of $137 million in 1997, compared to other expense, net, of $46 million in 1996, principally due to higher gains on asset sales, including an approximate $250 million pretax gain on the sale of an interest in E! Entertainment recognized in 1997. This income was offset in part by higher losses from reductions in the carrying value of certain investments and the dividend requirements on preferred stock of a subsidiary issued in February 1997. F-11 TIME WARNER INC. MANAGEMENT'S DISCUSSION AND ANALYSIS OF RESULTS OF OPERATIONS AND FINANCIAL CONDITION —(Continued) FINANCIAL CONDITION AND LIQUIDITY December 31, 1998 TIME WARNER 1998 Financia! Condition At December 31, 1998, Time Warner had $10.9 billion of debt, $442 million of available cash and equivalents (net debt of $10.5 billion), $895 million of borrowings against future stock option proceeds, $575 million of mandatorily redeemable prefened securities of a subsidiary and $8.9 billion of shareholders' equity, compared to $11.8 billion of debt, $645 million of available cash and equivalents (net debt of $11.2 billion), $533 million of borrowings against future stock option proceeds, $575 million of mandatorily redeemable preferred securities of a subsidiary, $1.9 billion of Series M Preferred Stock and $9.4 billion of shareholders' equity at December 31, 1997, Financing Activities During 1998, Time Warner continued its debt reduction efforts. Debt reduction of approximately $3 billion was partially offset by a$2.1 billion increase in debt in order to fu�d the 1998 redemption of Time Warner's Series M Preferred Stock. This debt reduction was achieved principally by using cash provided by operations, proceeds from certain asset sales, cash distributions from TWE and the noncash transfer of approximately $1 billion of debt to TWE-A/N as part of the TWE-A/N Transfers. In addition, during 1998, holders of Time Warner's $1.15 billion of zero-coupon convertible notes due 2013 (the. "Zero-Coupon Convertible Notes") converted their notes into an aggregate 37.4 million shares of Time Warner common stock. In order to partially offset the dilution resulting from this conversion; Time Warner incurred a corresponding $1.15 billion of debt and used the proceeds to repurchase common stock. Stock Option Pmceeds Credit Facility In early 1998, Time Warner entered into a new five-year, $1.3 billion revolving ciedit facility (the "Stock Option Proceeds Credit Facility"), which replaced its previously existing facility. Borrowings under the Stock Option Proceeds Credit Facility are principally used to fund stock repurchases and approximately $12 million of future. preferred dividend requirements on Time Wamer's convertible preferred stock. At December 31, 1998 and 1997, Time Warner had outstanding borrowings against future stock option proceeds of $895 million and $533 million, respectively. Because borrowings under the Stock Option Proceeds Credit Facility are expected to be principally repaid by Time Wamer from the cash proceeds related to the exercise of employee stock options, Time Warner's principal credit rating agencies have .concluded that such borrowings and related financing costs are credit neutral and are excludable from debt and interest expense, respectively, for their purposes in evaluaring Time Wamer's leverage and coverage ratios. In addition, because Time Warner has committed to use the Stock Option Proceeds Credit Faciliry to fund prefened dividend requirements on certain series of its convertible preferred stock, and has entered into certain escrow amangements, Time Warner's principal credit rating agencies similarly exclude such preferred dividend requirements for purposes of evaluating Time Warner's coverage ratio. See Note 8 to the accompanying consolidated financial statements for a summary of the principal terms of the Stock Option Proceeds Credit Facility. Redemption of Series M Preferred Stock In December 1998, Time Warner redeemed all of its outstanding shares of 101/a% Series M Preferred Stock. The aggregate redemption cost of approximately $2.1 billion was funded with proceeds from the F-12 TIME WARNER INC. MANAGEMENT'S DISCUSSION AND ANALYSIS OF RESULTS OF OPERATIONS AND FINANCIAL CONDITION —(Continued) issuance of lower-cost debt (the "1998 Series M Refinancing"). Because the weighted-average interest rate of the debt is approximately 375 basis points lower than the dividend rate of the Series M Preferred Stock and the interest on the debt is tax deductible (whereas dividends are not), Time Warner expects to realize approximately $100 to $125 million of annual cash savings as a result of this redemption. Preferred Stock Conversions During 1998 and January 1999, Time Warner issued approximately 66 million shares of common stock in connection with the conversion of 15.8 million shares of convertible preferred stock. These conversions are expected to result in approximately $60 million of cash dividend savings in the aggregate for Time Warner through the end of 1999. Common Stock Repurchase Program During 1998, Time Warner acquired 59.9 million shares of its common stock at an aggregate cost of $2.24 billion under its existing common stock repurchase program, thereby increasing the cumulative shares purchased to approximately 95.1 million shazes at an aggregate cost of $3.04 billion. Except for repurchases of common stock using borrowings in 1998 that offset $1.15 billion of debt reduction associated with the conversion of the Zero-Coupon Convertible Notes into common stock, these repurchases were funded with stock option exercise proceeds and borrowings under Time Warner's Stock Option Proceeds Credit Facility. In January 1999, Time Warner's Board of Directors authorized a new common stock repurchase program that allows the Company to repurchase, from time to time, up to $5 billion of common stock. This program is expected to be completed over a three-year period. However, actual repurchases in any period will be subject to market conditions. Along with stock option exercise proceeds and borrowings under the Stocic Option Proceeds Credit Facility, additional funding for this program is expected to be provided by anticipated future free cash flow and financial capacity. Credit Statistics The combination of EBITA growth, controlled capital spending and debt reduction has resulted in improvements in Time Warner's financial condition and overall financial flexibility, as reflected in its strengthening financial ratios. These ratios, consisting of commonly used financial measures such as leverage and coverage ratios, are used by credit rating agencies and other credit analysts to measure the ability of a company to repay debt (leverage) and to pay interest and preferred dividends (coverage). As a result of the continuing improvements in Time Warner's financial performance, each of Standard & Poor's and Moody's, Time Warner's principal credit rating agencies, upgraded Time Warner in 1998 to an improved investment- grade credit rating. The leverage and coverage ratios are set forth beIow for each of Time Warner and Time Warner and the Entertainment Group combined. Certain rating agencies and other credit analysts place more emphasis on the combined ratios, while others place more emphasis on the Time Wamer stand-alone ratios. It should be understood, however, that the assets of the Entertainment Group are not freely available to fund the cash needs of Time Warner. The leverage ratio represents the ratio of tota! debt, less available cash and equivalents, to total business segment operating income before depreciation and amortization, less corporate expenses ("Adjusted EBITDA"). The coverage ratio represents the ratio of Adjusted EBITDA to total interest expense and/or preferred dividends. F-13 TIME WARNER INC. MANAGEMENT'S DISCUSSION AND ANALYSIS OF RESULTS OF OPERATIONS AND FINANCIAL CONDITION —(Continued) Time Warner and Entertainment Group combined.• Leverage ratio ................................................ Interest coverage ratio�b� ....................................... Interest and preferred dividends coverage ratio�b>�`� Time Warner.� Historical 1998 1997 Pro Forma 1996(a) 3.Ox 3.2x 4.1 x 4.Ox 3.Sx 2.9x 3.3x 2.8x 2.3x Leverage ratio . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4.1x 4.Sx 5.9x Interest coverage ratio�b� . . . .. . ... . .. . . . . .. . . . . . . . . . . .. . . . . . . . 3.1x 2.Sx 2.Ox Interest and preferred dividends coverage ratio�b��`� . . . . . . . . . . . . . . . . . 2.3x 1.9x 1.Sx (a) Pro forma ratios for 1996 give effect to the 1996 Time Warner Transactions as if they had occurred at the beginning of 1996. Historical ratios for 1996 are not meaningful and have not been presented because they reflect the operating results of TBS for only a portion of the year in comparison to year-end net debt levels. (b) Excludes interest paid to TWE in connection with borrowings under Time Warner's $400 million credit agreement with TWE and excludes interest on borrowings under the Stock Option Proceeds Credit Facility. (c) Includes dividends related to certain preferred securities of subsidiaries. Excludes preferred dividends that Time Warner has funded with borrowings under the Stock Option Proceeds Credit Facility. casn FioWs During 1998, Time Warner's cash provided by operations amounted to $1.845 billion and reflected $2.296 billion of EBITA from its Publishing, Music, Cable Networks-TBS, Filmed Entertainment-TBS and Cable businesses, $378 million of noncash depreciation expense, $17 million of proceeds from Time Warner's asset securitization program and $698 million of distributions from TWE (excluding $455 million representing the return of a portion of the Time Wamer General Partners' Senior Capital interest that has been classified as a source of cash from investing activities), less $812 million of interest payments, $209 million of income taxes, $86 million of corporate expenses and $437 million related to an increase in other working capital requirements, balance sheet accounts and noncash items. Cash provided by operations of $1.408 billion in 1997 reflected $2.183 billion of business segment EBITA, $382 million of noncash depreciation expense, $108 million of proceeds from Time Warner's asset securitizarion program and $479 million of distributions from TWE (similarly excluding $455 million representing the return of a portion of the Time Warner General Partners' Senior Capital interest that has been classified as a source of cash from investing activities), less $929 million of interest payments, $253 million of income taxes, $81 million of corporate expenses and $481 million related to an increase in other working capital requirements, balance sheet accounts and noncash items. Cash provided by investing activities was $353 million in 1998, compared to cash used by investing activities of $45 million in 1997, principally as a result of lower capital expenditures and an increase in investment proceeds relating to Time Warner's debt reduction efforts, partially offset by an increase in cash used for investments and acquisitions. Cash used for investments and acquisitions in 1998 was offset in part by the effect of consolidating approximately $200 million of cash of Paragon Communications ("Paragon") in connection with the TWE-A/N Transfers. Capital expenditures decreased to $512 million in 1998, compared to $574 million in 1997. Cash used by financing activities was $2.401 billion in 1998, compared to $1.232 billion in 1997. During 1998, Time Warner issued approximately $2.1 billion of debt and used the proceeds therefrom to redeem its Series M Preferred Stock. Time Warner also had addirional bonowings in 1998 that offset the noncash reduction of $1.15 billion of debt relating to the conversion of the Zero-Coupon Convertible Notes into common stock. Time Warner used the proceeds from these borrowings, together with most of the combined F-14 TIME WARNER INC. MANAGEMENT'S DISCUSSION AND ANALYSIS OF RESULTS OF OPERATIONS AND FINANCIAL CONDITION —(Continued) $740 million of proceeds received from the exercise of employee stock options and $362 million of net borrowings against future stock option proceeds, to repurchase approximately 59.9 million shares of Time Warner common stock at an aggregate cost of $2.24 billion. In addition, Time Warner paid $524 million of dividends in 1998, reflecting its election in 1998 to pay dividends on its Series M Preferred Stock in cash rather than in-kind. Cash used by financing activities in 1997 principally resulted from approximately $1 billion of debt reducrion, the repurchase of approximately 12.4 million shares of Time Warner common stock at an aggregate cost of $344 million and the payment of $338 million of dividends, offset in part by proceeds received from the exercise of employee stock options. The assets and cash flows of TWE are restricted by certain borrowing and partnership agreements and are unavailable to Time Warner exc�pt through the payment of certain fees, reimbursements, cash distributions and loans, which are subject to limitations. Under its bank credit agreement, TWE is permitted to incur additional indebtedness to make loans, advances, distributions and other cash payments to Time Warner, subject to its individual compliance with the cash flow coverage and leverage ratio covenants contained therein. Management believes that Time Warner's operating cash flow, cash and equivalents and additional borrowing capacity are sufficient to fund its capital and liquidity needs for the foreseeable future without distributions and loans from TWE above those permitted by existing agreements. . ENTERTAINMENT GROUP 1998 Financial Condition At December 31, 1998, the Entertainment Group had $6.6 billion of debt, $87 million of cash and equivaients (net debt of $6.5 billion), $217 million of preferred stock of a subsidiary, $603 million of Time Warner General Partners' Senior Capital and $5.2 billion of partners' capital, compared to $6.0 billion of debt, $322 million of cash and equivalents (net debt of $5.7 billion), $233 million of preferred stock of a subsidiary, $1.1 billion .of Time Warner General Partners' Senior Capital and $6.4 billion of partners' capital at December 31, 1997. Net debt of the Entertainment Group increased in 1998 principally as a result of the TWE-A/N Transfers and increased borrowings to fund cash distributions paid to Time Warner, partially offset by appro�cimately $650 million of debt reduction associated with the formation of a cable television joint venture in Texas. (the "Texas Cable Joint Venture") with TCI Communications, Inc. ("TCI"), a subsidiary of Tele-Communications, Inc. . Credit Statistics Entertainment Group leverage and coverage ratios for 1998, 1997 and 1996 were as follows: Leverage ratio .......................................... Interest coverage ratio�d� .................................. (a) lncludes dividends related to thc preferred stock of a subsidiary. Cash Flows Historical 1998 1997 1996 2.1 x 2.Ox 2.4x 5.3x 5.4x 4.8x In 1998, the Entertainment Group's cash provided by operations amounted to $2.288 billion and reflected $2.233 billion of EBITA from the Filmed Entertainment-Warner Bros., Broadcasting-The WB Network, Cable Networks-HBO and Cable businesses, $927 million of noncash depreciation expense and $166 million from TWE's asset securitization program, less $537 million of interest payments, $91 million of income taxes, F-15 TIME WARNER INC. MANAGEMENT'S DISCUSSION AND ANALYSIS OF RESULTS OF OPERATIONS AND FINANCIAL CONDITION —(Continued) $72 million of corporate expenses and $338 million related to an increase in working capital requirements, other balance sheet accounts and noncash items. Cash provided by operations of $1.799 billion in 1997 reflected $1.891 billion of business segment EBITA, $956 million of noncash depreciation expense and $300 million from TWE's asset securitization program, less $493 million of interest payments, $95 million of income taxes, $72 million of corporate expenses and $688 million related to an increase in working capital requirements, other balance sheet accounts and noncash items. Cash used by investing activities was $745 million in 1998, compared to $1.217 billion in 1997, principally as a result of a$726 million increase in investment proceeds, offset in part by a reduction of cash flows from investments and acquisitions related to the deconsolidation of approximately $200 million of Paragon's cash in connection with the TWE-A/N Transfers. Investment proceeds increased principally due to TWE's debt reduction efforts, including proceeds from the sale of TWE's remaining interest in Six Flags Entertainment Corporation and the receipt of approximately $650 million of proceeds upon the formation of the Texas Cable Joint Venture. Capital expenditures were $1.603 billion in 1998, compared to $1.565 billion in 1997. Cash used by financing activities was $1.778 billion in 1998, compared to $476 million in 1997. The use of cash in 1998 principally reflected $1.153 billion of distributions paid to Time Warner and the use of investment proceeds to reduce debt in connection with TWE's debt reduction efforts. The use of cash in 1997 principally reflected $934 million of distributions paid to Time Warner, offset in part by $243 million of aggregate net proceeds from the issuance of preferred stock of a subsidiary and an increase in borrowings used to fund cash distributions to Time Warner. Management believes that the Entertainment Group's operating cash flow, cash and equivalents and additional borrowing capacity are sufficient to fund its capital and liquidity needs for the foreseeable future. Cable Capital Spending Time Warner Cable has been engaged in a plan to upgrade the technological capability and reliability of its cable television systems and develop new services, which it believes will keep the business positioned for sustained, long-term growth. Capital spending by Time Warner Cable, including the cable operations of both Time Warner and TWE, amounted to $1.676 billion in 1998, compared to $1.683 billion in 1997. Cable capital spending for 1999 is budgeted to be approximately $1.5 billion and is expected to continue to be funded by cable operating cash flow. In exchange for certain flexibility in establishing cable rate pricing structures for regulated services and consistent with Time Warner Cable's long-term strategic plan, Time Warner Cable agreed with the Federal Communications Commission (the "FCC") in 1996 to invest a total of $4 billion in capital costs in connection with the upgrade of its cable infrastructure. The agreement with the FCC covers all of the cable operations of Time Warner Cable, including the owned or managed cable television systems of Time Warner, TWE and TWE-A/N. As of December 31, 1998, Time Warner Cable had approximately $I billion remaining under this commitment. Management expects to satisfy this commitment by December 31, 2000 when Time Warner Cable's technological upgrade of its cable television systems is scheduled to be substantially completed. Cable Strategy In addition to using cable operating cash flow to finance the level of capital spending necessary to upgrade the technological capability of cable television systems and develop new services, Time Warner, TWE and TWE-A/N have completed or announced a series of transactions over the past year related to the cable television business and related ancillary businesses. These transactions consist of the TWE-A/N Transfers, the Primestar Roll-up Transaction, the Time Warner Telecom Reorganization, the formation of the Road Runner Joint Venture, the formation of the Texas Cable Joint Venture and other TCI-related cable F-16 TIME WARNER INC. MANAGEMENT'S DLSCUSSION AND ANALYSIS OF RESULTS OF OPERATIONS AND FIIVANCIAL CONDTTION —(Continued) transactions and the anticipated formation with AT&T Corp. ("AT&T") of a cable telephony joint venture (the "AT&T Cable Telephony Joint Venture"). All of these transactions have reduced, or will reduce, either existing debt and/or Time Warner's and TWE's share of future funding requirements for these businesses. In addition, the formation of the Road Runner Joint Venture and, ultimately, the AT&T Cable Telephony Joint Venture, when completed, will enable Time Warner Cable to leverage its technologically advanced, high-capacity cable azchitecture into new opportunities to create incremental value through the development and exploitation of new services with strategic partners, such as AT&T', Microsoft Corp. and Compaq Computer Corp. The proposed AT&T Cable Telephony Joint Venture is discussed more fully below and the other transactions are described in Note 2 to the accompanying consolidated financial statements. AT&T Cable Telephony Joint Venture In February 1999, Time Warner, TWE and AT&T announced their intention to form a strategic joint venture. This joint venture will offer AT&T-branded cable telephony service to residential and small business customers over Time Warner Cable's television systems for up to a twenty-year period. This transaction effectively will allow Time Warner Cable to leverage its existing cable infrastructure into a new growth opportunity in a non-core business, without the need for any incremental capital investment. Under the preliminary terms announced by the parties, the joint venture will be owned 22.5� by Time Warner Cable and 77.5% by AT&'T. AT&T will be responsible for funding all of the joint venture's negarive cash flow and Time Warner.Cable's equity interest in the joint venture will not be diluted as a result of AT&T's funding obligations. Because AT&T is expected to have significant funding obligations through at least the first three'years of the joint venture's operations when capital will be deployed and services first rolled-out, Time Warner Cable expects to benefit from the additional value created from its "carried" interest. In addition to its equity interest, Time Warner Cable is expected to receive the following payments from the joint venture: (i) Approximately $300 million of initial access fees, based on a rate of $15 per home passed that is payable in two annual installments once a particular service.area has been upgraded and powered for cable telephony service. Time Warner Cable is expected to receive additional access fees in the future as its cable television systems continue to pass new homes. (ii) Recurring monthly subscriber fees in the initial amount of $1.50 per telephony subscriber, to be adjusted periodically to up to $6.00 per telephony subscriber in the sixth year of providing cable telephony service to any particular area. In addition, the joint venture is expected to guarantee certain minimum penetrarion levels to Time Warner Cable, ranging from 5'90 in the second year of providing cable telephony service to any particular area to up to 253'o in the sixth year and thereafter. (iu) Additional monthly subscriber fees equal �0 15% of the excess, if any, of monthly average cable telephony revenues in a particular service area over $100, after the fifth year of providing cable telephony service to any particular area. Further, management believes that the opportunity for consumers to select one provider of AT&T- branded, "all-distance" wireline and wireless communication services will contribute to increased cable television penetration in Time Warner Cable's sen+ice areas and the continuing growth in Time Warner Cable's revenues from the delivery of cable television services. This transacrion is expected to close in the second half of 1999, subject to the execution of definitive agreements by the parties and customary closing conditions, including the� approval of Advance/Newhouse F-17 TIME WARNER INC. MANAGEMENT'S DISCUSSION AND ANALYSIS OF RESULTS OF OPERATIONS AND FINANCIAL CONDITION —(Continued) and MediaOne and all necessary governmental and regulatory approvals. There can be no assurance that such agreements will be completed or that such approvals will be obtained. Off-Balance Sheet Assets As discussed below, Time Warner believes that the value of certain off-balance sheet assets should be considered, along with other factors discussed elsewhere herein, in evaluating the Company's financial condition and prospects for future results of operations, including its ability to fund its capital and liquidity needs. Intangible Assets As a creator and distributor of branded information and entertainment copyrights, Time Warner and the Entertainment Group have a significant amount of internally generated intangible assets whose value is not fully reflected in their respective consolidated balance sheets. Such intangible assets extend across Time Warner's principal business interests, but are best exemplified by Time Warner's collection of copyrighted music product, its libraries of copyrighted film and television product and the creation or extension of brands. Generally accepted accounting principles do not recognize the value of such assets, except at the time they may be acquired in a business combination accounted for by the purchase method of accounting. Because Time Warner normally owns the copyrights to such creative material, it continually generates revenue through the sale of such products across different media and in new and existing markets. The value of film and television-related copyrighted product and trademarks is continually realized by the licensing of films and television series. to secondary markets and the licensing of trademazks, such as the Looney Tunes characters and Batman, to the retail industry and other markets. In addition, technological advances, such as the introducrion of the compact disc and home videocassette in the 1980's and, potentially, the current exploitation of the digital video disc, have historically generated significant revenue opportunities through the repackaging and sale of such copyrighted products in the new technological format. Accordingly, such intangible assets have significant off-balance sheet asset value that is not fully reflected in the consolidated balance sheets of Time Warner and the Entertainment Group. Filmed Entertainment Backlog Backlog represents the amount of future revenue not yet recorded from cash contracts for the licensing of theatrical and television product for pay cable, basic cable, network and syndicated television exhibition. Backlog of TWE's Filmed Entertainment-Warner Bros. division amounted to $2.298 billion at December 31, 1998 (including amounts relating to the licensing of film product to Time Warner's and TWE's cable television networks of $769 million). In addition, backlog of Time Warner's Filmed Entertainment-TBS division amounted to $636 million at December 31, 1998 (including amounts relating to the licensing of film product to Time Warner's and TWE's cable television networks of $226 million). Because backlog generally relates to contracts for the licensing of theatrical and television product which have already been produced, the recognition of revenue for such completed product is principally only dependent upon the commencement of the availability period for telecast under the terms of the related licensing agreement. Cash licensing fees are received periodically over the term of the related licensing agreements or on an accelerated basis using TWE's $500 million securitization facility. The portion of backlog for which cash has not already been received has significant off-balance sheet asset value as a source of future funding. The backlog excludes advertising barter contracts, which are also expected to result in the future realization of revenues and cash through the sale of advertising spots received under such contracts. F-18 TIME WARNER INC. MANAGEMENT'S DISCUSSION AND ANALYSIS OF RESULTS OF OPERATIONS AND FINANCIAL CONDITION —(Continued) Interest Rate and Foreign Currency Risk Management Interest Rate Swap Contracts Time Warner uses interest rate swap contracts to adjust the proportion of total debt that is subject to variable and fixed interest rates. At December 31, 1998, Time Warner had interest rate swap contracts to pay floating-rates of interest (average six-month LIBOR rate of 5.5°70) and receive fixed-rates of interest (average rate of 5.5%) on $1.6 billion notional amount of indebtedness, which resulted in approximately 37% of Time Warner's underlying debt, and 39% of the debt of Time Warner and the Entertainment Group combined, being subject to variable interest rates. At December 31, 1997, Time Warner had interest rate swap contracts on $2.3 billion notional amount of indebtedness. Based on Time Warner's variable-rate debt and related interest rate swap contracts outstanding at December 31, 1998, each 25 basis point increase or decrease in the level of interest rates would, respectively, increase or decrease Time Warner's annual interest expense and related cash payments by approximately $11 million, including $4 million related to interest rate swap contracts. Such potential increases or decreases are based on certain simplifying assumprions, including a constant level of variable-rate debt and related interest rate swap contracts during the period and, for all maturities, an immediate, across-the-board increase or decrease in the level of interest rates with no other subsequent changes for the remainder of the period. Foreign Exchange Contracrs Time Warner uses foreign exchange contracts primarily to hedge the risk that unremitted or future royalties and license fees owed to Time Wamer or TWE domestic companies for the sale or anticipated sale of U.S. copyrighted products abroad may be adversely affected by changes in foreign currency exchange rates. As part of its overall strategy to manage the level of exposure to the risk of foreign currency exchange rate fluctuations, Time Warner hedges a portion of its and TWE's combined foreign cunency exposures anticipated over the ensuing twelve month period. At December 31, 1998, Time Warner had effectively hedged approximately half of the combined esrimated foreign currency exposures that principally relate to anticipated cash flows to be remitted to the U.S. over the ensuing twelve month period. To hedge this exposure, Time Warner used foreign exchange contracts that generally have maturities of three months or less, which generally will be rolled over to provide continuing coverage throughout the year. Time Warner is reimbursed by or reimburses TWE for Time Warner contract gains and losses related to TWE's foreign currency exposure. Time Warner often closes foreign exchange sale contracts by purchasing an offsetting purchase contract. At December 31, 1998, Time Warner had contracts for the sale of $755 million and the purchase of $259 million of foreign currencies at fixed rates, compared to contracts for the sale of $507 million and the purchase of $139 million of foreign currencies at December 31, 1997. Based on the foreign exchange contracts outstanding at December 31, 1998, each 5% devaluation of the U.S. dollar as compared to the level of foreign exchange rates for currencies under contract at December 31, 1998 would result in approximately $38 million of unrealized losses and $13 million of unrealized gains on foreign exchange contracts involving foreign currency sales and purchases, respectively. Conversely, a 5% appreciation of the U.S. dollar would result in $38 million of unrealized gains and $13 million of unrealized losses, respectively. With regard to the net $25 million of unrealized losses or gains on foreign exchange contracts, Time Warner would be reimbursed by TWE, or would reimburse TWE, respectively, for approximately $10 million, net, related to TWE's foreign currency exposure. Consistent with the nature of the economic hedge provided by such foreign exchange contracts, such unrealized gains or losses would be offset by corresponding decreases or increases, respectively, in the dollar value of future foreign currency royalty and license fee payments that would be received in cash within the ensuing twelve month period from the sale of U.S. copyrighted products abroad. F-19 TIME WARNER INC. MANAGEMENT'S DISCUSSION AND ANALYSIS OF RESULTS OF OPERATIONS AND FINANCIAL CONDITION —(Continued) Global Financial Markets During 1998, certain financial markets, mainly Brazil, Russia and a number of Asian countries, experienced significant instability. Because less than 5% of the combined revenues of Time Warner and the Entertainment Group are derived from the sale of products and services in these countries, management does not believe that the state of these financial markets poses a material risk to the operations of Time Warner and the Entertainment Group. Euro Conversion Effective January 1, 1999, the "euro" was established as a single currency valid in more than two-thirds of the member countries of the European Union. These member countries have a three-year transitional period to physically convert their sovereign currencies to the euro. By July 1, 2002, all participating member countries must eliminate their curr�ncies and replace their legal tender with euro-denominated bills and coins. Notwithstanding this transitional period, many commercial transactions are expected to become eura denominated well before the July 2002 deadline. Accordingly, Time Warner continues to evaluate the short- term and long-term effects of the euro conversion on its European operations, principally publishing, music, cable networks and filmed entertainment. Time Warner believes that the most significant short-term impact of the euro conversion is the need to modify its accounting and information systems to handle an increasing volume of transactions during the transitional period in both the euro and sovereign currencies of the participating member countries. Time Warner has identified its accounting and information systems in need of modification and an action plan has been formulated to address the nature and timing of remediation efforts. Remediation efforts have begun and the plan is expected to be substantially completed well before the end of the transitional period. This timetable will be adjusted, if necessary, to meet the anticipated needs of Time Warner's vendors and customers. Based on preliminary information, costs to modify its accounting and information systems aze not expected to be material. Time Warner believes that the most significant long-term business risk of the euro conversion may be increased pricing pressures for its products and services bmught about by heightened consumer awareness of possible cross-border price differences.'However, Time Warner believes that these business risks may be offset to some extent by lower material costs, other cost savings and markering opportunities. Notwithstanding such risks, management does not believe that the euro conversion will have a material effect on Time Warner's financial position, results of operations or cash flows in future periods. Year 2000 Technology Preparedness Time Warner, together with its Entertainment Group and like most large companies, depends on many different computer systems and other chip-based devices for the continuing conduct of its business. Older computer programs, computer hardware and chip-based devices may fail to recognize dates beginning on January 1, 2000 as being valid dates, and as a result may fail to operate or may operate improperly when such dates are introduced. Time Warner's exposure to potential Year 2000 problems arises both in technological operations under the control of the Company and in those dependent on one or more third parties. These technological operations include information � technology ("IT') systems and non-IT systems, including those with embedded technology, hardwaze and software. Most of Time Warner's potential Year 2000 exposures are dependent to some degree on one or more third parties. Failure to achieve high levels of Year 2000 compliance could have a material adverse impact on Time Warner and its financial statements. F-20 TIME WARNER INC. MANAGEMENT'S DISCUSSION AND ANALYSIS OF RESULTS OF OPERATIONS AND FINANCIAL CONDITION —(Continued) The Company's Year 2000 initiative is being conducted at the operational level by divisional project managers and senior technology executives overseen by senior divisional executives, with assistance internally as well as from outside professionals. The progress of each division through the different phases of remediation-inventorying, assessment, remediation planning, implementadon and final testing-is actively overseen and reviewed on a regular basis by an executive oversight group that reports through the Company's Chief Financial Officer to the Audit Committee of the Board of Directors. The Company has generally completed the process of identifying potential Year 2000 dif�culties in its technological operations, including IT applications, IT technology and support, desktop hardware and softwaze, non-IT systems and important third party operations, and distinguishing those that are "mission critical" from those that are not. An item is considered "mission critical" if its Year 2000-related failure would significantly impair the abiliry of one of the Company's major business units to (1) produce, market and distribute the products or services that generate significant revenues for that business, (2) meet its obligations to pay its employees, artists, vendors and others or (3) meet its obligations under regulatory requirements and internal accounting controls. The Company and its divisions, including the Entertainment Group, have identified approximately 1,000 worldwide, "mission cridcal" potential exposures. Of these, as of December 31, 1998, approximately 39°Io have been identified by the divisions as Year 2000 compliant, approximately 46% as in the remediation implementation or final testing stages, approximately 14% as in the remediation planning stage and less than 1% as still in the assessment stage. The Company currently expects that the assessment phase for the few remaining potential exposures should be completed during the first quarter of 1999 and that remediation with respect to approximately 80% of all these identified operations will be substantially completed in all material respects by the end of the second quarter of 1999. The Company, however, could experience unexpected delays. The Company is currently planning to impose a"quiet" period at the beginning of the fourth quarter of 1999 during which any remaining remediation involving installation or modification of systems that interface with other systems will be minimized to permit the Company to conduct testing in a stable environment. As stated above, however, the Company's business is heavily dependent on third parties and these parties are themselves heavily dependent on technology. In some cases, the Company's third pazty dependence is on vendors of technology who are themselves working towards solutions to Year 2000 problems. For example, in a situation endemic to the cable industry, much of the Company's headend equipment that controls cable set- top boxes was not Year 2000 compliant as of December 31, 1998. The box manufacturers are working with cable industry groups and have developed solutions that the Company is installing in its headend equipment. It is currently expected that these solutions will be substantially implemented by the end of the second quarter of 1999. In other cases, the Company's third party dependence is on suppliers of products or services that are themselves computer-intensive. For example, if a television broadcaster or cable programmer encounters Year 2000 problems that impede its ability to deliver its programming, the Company will be unable to provide that programming to its cable customers. Similarly, because the Company is also a programming supplier, third- party signal delivery problems could affect its ability to deliver its programming to its customers. The Company has attempted to include in its "mission critical" inventory significant service providers, vendors, suppliers, customers and govemmental entities that are believed to be critical to business operations and is in various stages of ascertaining their state of Year 2000 readiness through various means, including question- naires, interviews, on-site visits, system interface testing and industry group participarion. Moreover, Time Warner is dependent, like all large companies, on the continued functioning, domestically and internationally, of basic, heavily computerized services such as banking, telephony and power, and various distribution mechanisms ranging from the mail, railroads and trucking to high-speed data transmission. T'ime Warner is taking steps to attempt to satisfy itself that the third parties on which it is heavily reliant are Year 2000 compliant or that altemate means of ineeting its requirements are available, but cannot predict the likelihood of such compliance nor the direct or indirect costs to the Company of non-compliance by those third parties or of securing such services from alternate compliant third parties. In azeas in which the Company is uncertain F-21 TIME WARNER INC. MANAGEMENT'S DISCUSSION AND ANALYSIS OF RESULTS OF OPERATIONS AND FINANCIAL CONDITION —(Continued) about the anticipated Year 2000 readiness of a significant third party, the Company is investigating available alternatives, if any. The Company, including the Entertainment Group, currently estimates that the aggregate cost of its Year 2000 remediation program, which started in 1996, will be approximately $125 to $175 million, of which an estimated 45% to 55% has been incurred through December 31, 1998. These costs include estimates of the costs of assessment, replacement, repair and upgrade, both planned and unplanned, of certain IT and non-IT systems and their implementation and testing. The Company anticipates that its remediation program, and related expenditures, may continue into 2001 as temporary solurions to Year 2000 problems are replaced with upgraded equipment. These expenditures have been and are expected to continue to be funded from the Company's operating cash flow and have not and are not expected to impact materially the Company's financial statements. Management believes that it has established an effective program to resolve all significant Year 2000 issues in its control in a timely manner. As noted above, however, the Company has not yet completed all phases of its program and is dependent on third parties whose progress is not within its control. In the event that the Company does not complete any of its currently planned additional remediation prior to the Year 2000, management believes that the Company could experience significant difficulty in producing and delivering its products and services and conducting its business in the Year 2000 as it has in the past. In addition, disruptions experienced by third parties with which the Company does business as well as by the economy generally could also materially adversely affect the Company. The amount of potential .liability and lost revenue cannot be reasonably estimated at this time. The Company has been focusing its efforts on identification and remediation of its Year 2000 exposures and has not yet developed significant, specific contingency plans in the event it does not successfully complete all phases of its Year 2000 program. The Company, however, has begun to examine its existing standard business interruption strategies to evaluate whether they would satisfactorily meet the demands of failures arising from Year 2000-related problems. The Company intends to examine its status periodically to determine the necessity of establishing and implementing such contingency plans or additional strategies, which could involve, among other things, manual workarounds, adjusting staffing strategies and sharing resources across divisions. � Caution Concerning Forward-Looking Statements The Securities and Exchange Commission encourages companies to disclose forward-looking information so that investors can better understand a company's future prospects and make informed investment decisions. This document, together with management's public commentary related thereto, contains such "forward- looking statements" within the meaning of the Private Securities Litigation Reform Act of 1995, particularly statements anticipating future growth in revenues, EBITA and cash flow. Words such as "anticipate," "estimate," "expects," "projects," "intends," "plans," "believes" and words and terms of similar substance used in connection with any discussion of future opetating or financial performance identify such forward- looking statements. Those forward-looking statements are management's present expectations of future events. As with any projection or forecast, they are inherently susceptible to changes in circumstances, and the Company is under no obligation to (and expressly disclaims any such obligation to) update or alter its forward-looking statements whether as a result of such changes, new information or otherwise. Time Warner operates in highly competirive, consumer driven and rapidly changing media and entertainment businesses that are dependent on government regularion and economic, political and social conditions in the countries in which they operate, consumer demand for their products and services, technological developments and (particularly in view of technological changes) protection of their intellectual property rights. Time Warner's actual results could differ materially from management's expectations because F-22 TIME WARNER INC. MANAGEMENT'S DISCUSSION AND ANALYSIS OF RESULTS OF OPERATIONS AND FINANCIAI_ CONDITION —(Continued) of changes in such factors. Some of the other factors that also could cause actual results to differ from those contained in the forward-looking statements include those identified in Time Warner's other filings and: • For Time Warner's cable business, more aggressive than expected competition from new technologies and other types of video programming distributors, including DBS; increases in govemment regulation of cable or equipment rates (or any failure to redvice rate regulation as is presently mandated by statute) or other terms of service (such as "digital must-carry" or "unbundling" requirements); increased difficulty in obtaining franchise renewals; the failure of new equipment (such as digital set- top boxes) or services (such as high-speed online services or telephony over cable or video on demand) to function properly, to appeal to enough consumers or to be available at reasonable prices and to be delivered in a timely fashion; and greater than expected increases in programming or other costs. • For Time Warner's cable programming and television businesses, greater than expected programming or production costs; public and cable operator resistance to price increases (and the negative impact on premium programmers of increases in basic cable rates); increased regulation of distribution agree- ments; the sensitivity of advertising to economic cyclicality; and greater than expected fragmentation of consumer viewership due to an increased number of programming services or the increased popularity of altematives to television. • For Time Warner's film and television businesses, their ability to continue to attract and select desirable talent and scripts at manageable costs; increases in production costs generally; fragmentation of consumer leisure and entertainment rime (and its possible negative effects on the broadcast and cable networks, which are significant customers of these businesses); continued popularity of inerchan- dising; and the uncertain impact of technological developments such as DVD and the Intemet. • For Time Warner's music business, its ability to continue to attract and select desirable talent at manageable costs; the timely completion of albums by major artists; the popular demand for particular artists and albums; its ability to continue to enforce its intellectual property rights in digital environments; and the overall strength of global music sales. • For Time Warner's print media and publishing businesses, increases in paper and distribution costs; the introduction and increased popuiarity of altemative technologies for the provision of news and information, such as the Internet; and fluctuations in advertiser and consumer spending. • The ability of the Company and its key service pmviders, vendors, suppliers, customers and govemmental entities to replace, modify or upgrade computer systems in ways that adequately address the Year 2000 issue, including their abiliry to identify and correct all relevant computer codes and embedded chips, unanticipated difficulties or delays in the implementation of the Company's remediation plans and the ability of third parties to address adequately iheir own Year 2000 issues. In addition, Time Warner's overall financial strategy, including growth in operations, maintaining its financial ratios and strengthened balance sheet, could be adversely affected by increased interest rates, failure to meet earnings expectations, significant acquisitions or other transactions, consequences of the euro conversion and changes in Time Warner's plans, strategies and intentions. F-23 TIME WARNER INC. CONSOLIDATED BALANCE SHEET December 31, (millions, except per share amounts) t998 ASSETS Current assets Cash and equivdlents ...................................... .................................... $ 442 Receivables, less allowances of $1.007 billion and $991 million ............... ............ ....... .. ..... 2,885 inventories..................................................................................... 946 Prepaid expenses ...........:.................................................................... 1,176 Totalcurrent assets .............................................................................. 5,449 Noncurtentinventories ........................................................................... Investments in and amounts due to and from Entertainment Group .. .. . . . . . . . . . . . . . . . . . . . . .. .. .. . . .. . . . Otherinvestments ........................................:...................................... Property,Plant and equipment,net ................................................................. Music catalogues, contracts and copyrights ...... .............. ...... . ... .. ............ ......... .... . Cabletelevision and sportsfranchises ............................................................... Goodwill.............................................................:......................... Otherassets:................................................................................... 1,900 4,980 794 1,991 876 2,868 11,919 863 Totalassets..................................................................................... $31,640 LIABILITIES AND SHAREHOLDERS' EQUITY Current liabilities Accounts payable... .......................................................................... $ 996 ... Participations, royalties and programming costs payable ................ ...... ............ .............. 1,199 Debt due within one year ......................................................................... 19 Othercurrentliabilities ........................................................................... 2,404 Total current liabilities . . . . . ... . . . . . . .... . . .. .. . .. . ..... .. .. .. . . . . . . . . . . . . . . .. .. .. . . . .. .. .. .. . . . . . 4,618 Long-term debt .................................. ............................................ ... Borrowings againstfuture stock option proceeds ...................................................... Deferred incometaxes ........................................................................... Uncamed portion of paid subscriptions ............................:................................. Otherliabilities................................................................................. Company-obligated mandatorily redeemable preferred securities of e subsidiary holding solely subordinated debentures of a subsidiary of the Company . . . . . . . . . . . . .. . .... . .. . . . . . . . . . . .. . . . . . . . . . . . . . . . . . . .. . . . Series M exchangeable preferred stock, $.10 par value, 1:9 million shares outstanding in 1997 with a$1.903 billion liquidation preference . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Shareholders' equity Prefernd stock, $.10 par value, 22.6 and 35.4 million shares outstanding, $2.260 and $3.539 billion liquidation preference.......... ....................................................................... Series LMCN-V Common Stock, $.01 par value, 57.1 million shares outstanding . .. ........ . ... ... . .. .. . . . Common stock, $.01 par value, 1.118 and 1.038 billion shares ouutanding . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Paid-in capital .................................................................................. Accumulated deficit ............................................................................. Totalshareholders'equity ......................................................................... Total liabilities and shareholders' equity . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . See accompanying notes. F-24 10,925 895 3,491 741 1,543 575 2 1 11 13,134 (4,296) 8,852 531,640 1997 $ 645 2,447 830 1,089 5,011 1,766 5,549 I ,495 2,089 928 3,982 12,572 771 $34,163 $ 912 I ,072 8 2,379 4,371 11,833 533 3,960 672 1,006 575 1,857 4 1 10 12,675 (3,334) 9,356 $34,163 TIME WARNER INC. CONSOLIDATED STATEMENT OF OPERATIONS Years Ended December 31, (millions, except per share amounts) 1998 1997 1996 Revenues�,� ......................................................................... $ 14,582 $ 13,294 $10,064 Cost of revenues�"��"� . .. . . . . . . . . . . . ..... . 8,210 7,542 5,922 ............................................ Selling, general and administrative�:'�c"� . ...... ...... .. . . .. . . . .. . ...... ......... . .... .. . . . 4,876 4,481 3,176 Operating expenses ................................................................... 13,086 12,023 9,098 Business segment operating income .......... .... .. .... .. ................... .... . ... .. . . 1,496 1,271 966 Equity in pretax income of Entertainment Group�a� .. .. .. .. .. .. .. .. .. . . .. . .. . . .. . . . . . . . . . . 356 686 290 Interest and other, net�a� . . .. .. . ... .................. ... ... ................ .... .... .... 1,180 Corporate expenses�a� � � �� 4� ................................................................. (86) (81) (78) Income before income taxes ........................................................... 586 832 4 Income taxes ........................................................................ (418) (531) (160) lncome (loss) before extraordinary item . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 168 301 (156) Extraordinary loss on retirement of debt, net of $37 and $22 million income tax benefit in 1997 and 1996,respectively .............................................................. — (95) (35) Netincome(loss) ................................................................... 168 246 (191) Preferred dividend requiremenu�`� (540) (319) (257) Net loss applicable to common shares . . ... . .. .. . . . . .. . . .. . . . . . . . . . .. . . .. .. . . . . . . . . . . . . . . $ (372) $ (73) $ (448) Basic and diluted loss per common share: Loss before extraordinary item . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ (.31) $ (.01) $ (.48) Netloss............................................................................ $ (.31) $ (.06) $ (.52) Average common shares .............................................................. ],194.7 1,135.4 862.4 (a) Includes the following income (expenses) resulting from transactions with the Entertainment Group and other related companies for the years ended December 31, 1998, 1997 and 1996, respectively: revenues-$487 million, $384 million and $224 million; cost of rovenues-$(322) million, $(245) miilion and $(177) million; selling, general and administrative-$(40) million, $(53) million and $34 million; equity in pretax income of Entertainment Group-$105 million, $5 million and $(29) million; interost and other, net-$(9) million, $(36) million and $(33) million; and corporate expenses-$72 million, $72 million and $69 million (Note 18). (b) Includes depreciation and amortization expense of : .. ............... ................ ... $ 1,178 $ 1,294 $ 988 (c) Preferred dividend requirements for 1998 include a one-time ef%ct of $234 million ($.19 loss per common share) relating to the premium paid in connection with the redemption of the Company's IO�k96 Series M exchangeable preferred stock ("Series M Preferred Stock") at an aggregate cost of approximately $2.1 billion (Note 11). See accompanying notes. F-25 TIME WARNER INC. CONSOLIDATED STATEMENT OF CASH FLOWS Years Ended December 31, ( millions) OPERATIONS Netincome (loss) .................................................................... $ Adjustments for noncash and nonoperating items: Extraordinary loss on retirement of debt . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Depreciation and amortization .. .. . ... ... ...... ...... . .. . ........ ... ...... ...... ... .. ... Noncash interest expense ............................................................... Excess (deficiency) of distributions over equity in pretax income of Entertainment Group ........ Equity in losses (income) of other investee companies aRer distributions . . . . . . . . . . . . . . . . . . . . . . . . . Changes in operating assets and liabilities: 1998 1997 1996 i68 $ 246 $ (191) — 55 35 1,178 1,294 988 30 98 96 342 (207) (62) 147 36 (53) Receivables........................................................................ (597) ]nventories ......................................................................... (312) Accounts payable and other liabilities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 810 Other balance sheetchanges .......................................................... 79 Cash provided by operations ............................................................ iNVESTING ACTIVITIES Investments and acquisitions ............................................................ Capitalexpenditures ................................................................... Investmentproceeds ................................................................... Proceeds received from distribution of TWE Senior Capital . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Cash provided (used) by investing activities ............ ... ............ ...... .............. 1,845 (159) (512) 569 455 353 FINANCING ACfIVITIES Borrowings........................................................................... 3,743 Debtrepayments...................................................................... (2,317) Borrowings againstfuture stock option proceeds ............................................ I,O15 Repayments of borrowings against future stock option proceeds ...... . . . . .. . .. . ... .. . ... . .... (653) Repurchases of Time Warner common stxk . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (2,240) Redemption of Serics M Preferred Stock ................................................. (2,093) Issuance of Series M Preferred Stock .... . . . .. .. .. .. ..... . ....... . .. . ... ... . . . .. . ... .. ... — Dividendspaid ....................................................................... (524) Proceeds received from stock option and dividend reinvestment plans . . . . . . . . . . . . . . .. . .. . . . . . . 740 Other, principally financing costs . . . ..... . . . . . . . .. . . . .... ...... .. .. . . . . . . . . . . .. . . . .. . . . . . (72) Cash used by financing activities . . . . . . . . . . . . . . . . . . . . . . . . . . . . .. . . . . . . . . . . . . . . . . . . . .. . . . . . (2,401) 1NCREASE (DECREASE) IN CASH AND EQUIVALENTS .............................. (203) CASH AND EQUIVALENTS AT BEGINNING OF PERIOD�'� . . .. . . . . . . . . . . . . . . . . . . . . . . . . 645 CASH AND EQUIVALENTS AT END OF PERIOD�'� ... ... ......... .... ................ $ 442 (a) Includes current and noncurrent cash and equivalents at December 31, 1996 and I995. See accompanying notes. F-26 (167) (84) 501 (364) I ,408 (113) (574) 187 455 (39) (180) ��8) 67 253 (261) (481) 318 (45) (424) 5,413 (6,394) 230 (185) (344) (338) 454 (68) (1,232) 131 Sl4 $ 645 3,431 �S.z7� ) 488 (456) 1,550 (287) 105 ��) (500) (671) 1,185 $ 514 TIME WARNER INC. CONSOLIDATED STATEMENT OF SHAREHOLDERS' EQUITY (millions) BALANCE AT DECEMBER 31, 1995 . .. . . .. . . ... . .. .. . . . .. . . .. . . Tfetloss .................................... .................. Increase in unrealized gains on securities, net oP $I I million taxexpense .................................................. Foreign curcency translation adjustments . . . . . . . . . . . . . . . . . . . . . . . . . . . Comprehensive income (loss) . .. . ... . .... . .. ... ... . . . .. . . . . . .. . Common stock dividends . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Preferred stock dividends ........................................ Issuance of common and preferred stock in the CV[ acquisition ... ... . Reduction in par value of common and preFerred stock due to TBS Transaction ........................ ......................... Issuance of common stock in the TBS Transaction .. ... .. .. ... . . . . . . Repurchascs of Time Warner common stock . . . . . .. . . . . . . . . . . . . . . . . Shares issued pursuant to stock option, dividend reinvestment and benefit plans ................................................. Other........................................................ BALAiVCE AT DECEMBER 31, 1996 ... ............ . . .. ..... .. .. Netincome ................................................... Decrease in unrealized gains on securities, net of S89 million tax benefit�'� ............:....................................... Foreign currency translation adjustments . . . . . . . . . . . . . . . . . . . . . . . . . . . Comprehensive income (loss) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Common stock dividends . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Preferrod stock dividends . . . . . . . . , . , . . , . , . .. ... ............ . lssuance of common stock in connection with the TBS Ttansaction .... Repurchases of Time Warner common stock . . . . . . . . . . . . . . . . . . . . . . . Shares issued pursuant to stock option, dividend reinvestment and benefit plans ................................................. Other........................................................ BALANCE AT DECEMBER 31, 1997 ...... . ...... .. ... . ..... ... . N etincome ................................................... Foreign currency translation adjustments . . . . . . . . . . . . . . . . . . . . . . . . . . . Increase in realized and unrexlized losses on dertvative financial instruments, net of $I3 million tax benefit . ............. ... .... .. . Cumulative eflcct of change in accounting for derivative financial instruments, net of $3 million tax benefit ......................... Comprehensive income (loss) . ... .. .. .. .. .. ..... .. .. . ...... ... . Common stock dividends . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Preferred stock diyidends ........................................ Issuance oF common stock in connection with the conversion of zero- coupon oonvertible notes due 2013 .............................: Issuance of common stock in connection with the conversion of convertible preferred stock ..................................... Repurchases of'Time Wamer common stock ............ ........... Shares issued pursuant to stock option, dividend reinvestment and benefitplans .................................................. BALANCE AT DECEMBER 31, 1998 ... ............. ..... .. .. ... Preferred Common Paid-In Accumulated Stock Stock Capital De6cit $ 30 $ 776 $ 5,034 $(2,173) (191) 17 9 (165) (I55) (257) 6 6 668 (32) (774) 806 3 6,024 (456) 163 (8) 6 4 11 12,245 (2,758) 246 4 ll 67 (344) 71l (4) 12,675 I,150 (2) 1 I51 (I) (2,239) I 1,397 $ 2 $ 12 $13,134 (128) (76) 42 (204) (319) (98) 3 (3,334) t68 4 (20) (18) 134 (2.16) (540) (150) (190) $(4,296) Total $ 3,667 (191) 17 9 (165) (I55) (257) 680 6,027. (456) 155 6 9,502 246 (128) (76) 42 (204) (319) 67 (344) 613 (t) 9,356 168 4 (20) (18) 134 (216) (540) 1,150 (2>240) 1,208 $ 8,852 (a) (ncludes a$13 million reduction (net of a S9 million tax effect) related to realized gains on the sale of securities in 1997. In prior periods, this amount wac included in comprchensive income as a component of Time Warner's unrealized gains on securities. See accompanying notes. F-27 TIME WARNER INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 1. ORGANIZATION AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES Description of Business Time Warner Inc. ("Time Warner" or the "Company"), together with its consolidated and unconsoli- dated subsidiaries, is the world's leading media and entertainment company. Time Wamer's principal business objective is to create and distribute branded information and entertainment copyrights throughout the world. Time Warner classifies its business interests into four fundamental areas: Cable Networks, consisting principally of interests in cable television programming; Publishing, consisting principally of interests in magazine publishing, book publishing and direct marketing; Entertainment, consisring principally of interests in recorded music and music publishing, filmed entertainment, television production and television broadcast- ing; and Cable, consisting principally of interests in cable television systems. A majority of Time Warner's interests in filmed entertainment, television production, television broadcasting and cable television systems, and a portion of its interests in cable television programming are held through Time Warner Entertainment Company, L.P. ("TWE"). Time Warner owns general and limited partnership interests in TWE consisting of 74.49% of the pro rata priority capital ("Series A Capital") and residual equity capital ("Residual Capital"), and 100% of the senior priority capital ("Senior Capital") and junior priority capital ("Series B Capital"). 1"he remaining 25.51% limited partnership interests in the Series A Capital and Residual Capital of TWE are held by a subsidiary. of MediaOne Group, Inc. ("MediaOne"), formerly U S WEST, Inc. Time Wamer does not consolidate TWE and certain related companies (the "Entertainment Group") for financial reporting purposes because of certain limited partner- ship approval rights related to TWE's interest in certain cable television systems. Each of the business interests within Cable Networks, Publishing, Entertainment and Cable is important to management's objective of increasing shareholder value through the creation, extension and distribution of recognizable brands and copyrights throughout the world. Such brands and copyrights include (1) leading cable television networks, such as HBO, Cinemax, CNN, TNT and the TBS Superstation, (2) magazine franchises such as Time, People and Sports Illustrated and direct marketing brands such as Time Life Inc. and Book-of-the-Month Club, (3) copyrighted music from many of the world's leading recording artists that is produced and distributed by a family of established record labels such as Warner Bros. Records, Atlantic Records, Elektra Entertainment and Warner Music Intemational, (4) unique and extensive film, television and animation libraries of Warner Bros. and Turner Broadcasting System, Inc. ("TBS"), and trademarks such as the Looney Tunes characters, Batman and The Flintstones, (5) The WB Network, a national broadcasting network launched in 1995 as an extension of the Warner Bros. brand and as an additional distribution outlet for the Company's collection of children's cartoons and television programming and (6) Time Warner Cable, currently the largest operator of cable television systems in the U.S. The operating results of Time Warner's various business interests are presented herein as an indication of financial performance (Note 16). Except for start-up losses incurred in connection with The WB Network, Time Warner's principal business interests generate significant operating income and cash flow from operations. The cash flow from operations generated by such business interests is considerably greater than their operating income due to significant amounts of noncash amortizarion of intangible assets recognized in various acquisitions accounted for by the purchase method of accounting. Noncash amortization of intangible assets recorded by Time Warner's business interests, including the unconsolidated business interests of the Entertainment Group, amounted to $1.309 billion in 1998, $1.342 billion in 1997 and $1.117 billion in 1996. Basis of Presentation The consolidated financial statements of Time Warner reflect the acquisition on October 10, 1996 of the remaining 80% interest in TBS that it did not already own and certain cable-related transactions, as more fully described herein (Notes 2 and 3). As a result of the acquisition of TBS, a new parent company with the name "Time Warner Inc." replaced the old parent company of the same name (now known as Time Wamer F-28 TIME WARNER INC. NOTES TO CONSOLIDATED FIiVANCIAL STATEMENTS —(Continued) Companies, Inc., "TW Companies"), and TW Companies and TBS became separate, wholly owned subsidiaries of the new parent company. References herein to "Time Wamer" or the "Company" refer to TW Companies prior to October 10, 1996 and Time Warner Inc. thereafter. Common stock, paid-in-capital, stock options, per common share and average common share amounts for all prior periods have been restated to give eSect to a two-for-one common stock split that occurred on December 15, 1998. In addition, certain reclassifications have been made to the prior years' financial statements to conform to the 1998 presentation. Basis of Consolidation and Accounting for Investments The consolidated financial statements include 100% of the assets, liabilities, revenues, expenses, income, loss and cash flows of Time Warner an� all companies in which Time Warner has a controlling voting interest ("subsidiaries"), as if Time Warner and its subsidiaries were a single company. Significant intercompany accounts and transactions between the consolidated companies have been eliminated. Significant accounts and transactions between Time Waraer and the Entertainment Group are disclosed as related party transactions (Note 18). The Entertainment Group and investments in certain other companies in which Time Warner has significant influence, but less .than a controlling voting interest, are accounted for using the equity method. Under the equity method, only Time Warner's investment in and amounts due to and from the equity investee are included in the consolidated balance sheet, only Time Warner's share of the investee's earnings is included in the consolidated operating results, and only the dividends, cash distributions, loans or other cash received from the investee, less any additional cash investments, loan repayments or other cash paid to the investee are included in the consolidated cash flows. Investments in companies in which Time Warner does not have a controlling interest or an ownership and voting interest so large as to exert significant influence aze accounted for at market value if the investme{►ts are publicly traded and there are no resale restrictions, or at cost, if the sale of a publicly-traded investment is restricted or if the investment is not publicly traded. Unrealized gains and losses on investments accounted for at market value are reported net-of-tax in accumulated deficit until the investment is sold, at which time the realized gain or loss is included in income. Dividends and other distributions of earnings from both market value and cost method investments are included in income when declared. The ef%ct of any changes in Time Waraer's ownership interests resulting from the issuance of equity capital by consolidated subsidiaries or equity investees to unat�liated parties is included in income. Foreign Currency Translation The financial position and operating results of substantially all foreign operations are consolidated using the local currency as the functional currency. Local currency assets and liabilities are translated at the rates of exchange on the balance sheet date, and local currency revenues and expenses are translated at average rates of exchange during the period Resulting translarion gains or losses, which have not been material, are included in accumulated deficit Use of Fstimates The preparation of financial statements in conformity with generally accepted accounring principles requires management to make estimates and assumptions that affect the amounts reported in the financial statements and footnotes thereto. Actual results could differ from those estimates. Significant estimates inherent in the preparation of the accompanying consolidated financial statements include management's forecast of anticipated revenues from the sale of future and existing music and publishing-related products, as well as from the distribution of theatrical and television product, in order to F-29 TIME WARNER INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS —(Continued) evaluate the u,ltimate ,recoverability of accou�ts; receivables, film inventory and artist and author advances recorded as , assets. in the consolidated balanee sheet. Accounts receivables and sales in the musia and publishing industries, as well as sales of ho�e video product in the filmed,entertainment industry, are subject to customers' rights to return unsold items. Management periodically reviews such estimates and it is reasonably possible' that management's assessment of recoverability of accounts receivables, individual films � and television product and individual artist and autfior' advances may change based on actual results and other factors. " ° Revenues and Costs Publishing and Music The unearned portion of paid magazine subscriptions is defened until magazines are delivered to subscribers. Upon each delivery, a proportionate share of the gross. subscription price is included in revenues. Magazine advertising revenues are recognized when the advertisemenis are published. In accordance with industry practice, certain products (such as magazines, books, home videocassettes, compact discs and cassettes) are sold to customers with the right to return unsold items. Revenues from such sales are recognized when the products are shipped based on gross sales less a provision for future returns. 'Inventories of magazines, books; cassettes ar�d compact discs are stated at the lower of cost or estimated realizable value. Cost is determined using first-in, frrst-out; last-in, first-out; and average cost methods. Returned goods included in inventory aie valued at estimated realizable value, but not in excess of cost. Cable and Cab1e Networks ' A significant portion of cable system and cable network programming revenues are derived from su6scriber fees and advertising:�Subscriber fees aze recorded as revenue in the period the service is provided and advertising rev�nues are recognized in'the penod' �hat the advertisements are exhibited. The costs of rights to exhibit feature films and other programming on the cable networks during one or more availability periods ("programming costs") generally aze recorded when the programming is initially available for exhibition, and aie allocated to the appropriate availabilify periods and amortized as the programming is exhibited. Filmed Entertainment � Feature films are produced or acquired for initial exhibirion in theaters followed by distribution in the home video, pay cable, basic cable, broadcast network and syndicated television markets. Generally, distribution to the theatrical, home video and pay cable markets (the primary markets) is principally completed within eighteen months of initial release. Thereafter, feature films are distributed to the basic cable, broadcast network and syndicated t�levision ma;kets (the secondary. :markets). Theatrical revenues are recognized as the films are exhibited. Home video revenues, less a provision for returns, are recognized when the home videos are sold. Revenues from,.the distribution of theatrical product xo cable, broadcast network and syndicated televisian marke,ts aze recognized when the films are available to telecast. Television films and series are initially produced for the networks or first-run television syndication (the primary markets) and may be subsequently licensed to foreign or domestic cable and syndicated television markets (the secondary markets). Revenues from the distribution of television product are recognized when the films or series are available to teleeast, except for barter agreements where the recognition of revenue is defeaed until the related advertisements are exhibited. License agreements for the telecast of theatrical and television product in the cable, broadcast network and syndicated television markets are routinely entered into well in advance of their available date for telecast, which is generally determined by the telecast privileges granted under previous license agreements. Accord- ingly, there are significant contractual rights to receive cash and barter under these licensing agreements. Por F-30 TIME W�RNER• IN.C. NOTES TO CONSOLIDATED FIN�iI�IC�AL STATEIV�ENTS —(Continued) cash contracts, the related revenues will not be r�cognized unfil such product is available for telecast under the contractual. terms of the related license agreement. For .ba�ter contract�s, the .related revenues will not be recognized until the product is available for telecast and �t�e advertising spots received under such contracts are either used or sold to third,parties. All,of these contractual rights for which revenue is not yet recognizable is refeaed to as "backlog." , Inventories of theatrical and television product are stated at the lower of amortized cost or net realizable value. Cost principally consists of direct producdon costs and production overhead. A portion of the cost to acquire TBS in 1996 was ailocated to its theatrical and television product, including an allocarion to purchased program rights (such as the animation library of Hanna-Bazbera Inc. and the former film and television libraries of Metro-Goldwyn-Mayer, Inc. and RKO Pictures, Inc.) and product that had.been exhibited at least once in all markets ("Library"). Library product is amortized on a straight-line basis over twenty years. Individual films and series are amortized, and the related participations and residuals , are accrued, based on the proportion that current revenues from the film or series bear to an estimate of total revenues anticipated frorn all markets. These estimates are revised periodically and losses, if any, aze provided in full. Current film inventories generally include the unamortized cost of completed � featuie films atlocated to the primary markets, felevision films and series in production pursuant to a contract of sale, film rights acquired for the hor�e video market'and advances pursuant to:agreements to�distribute third-party films in the primary markets. Noncurrent film inventories� generally include the un�mortized cost of completed theatrical and television fiims allocated to the�seeondary mazkets, theatrical films in production�and the Library. `�roposed Changes to Film Accountrrig.Standards. - - In October 1998, the Accounting Standazds Executive Committee of the American Institute of Certified Publi� Accountants ("�cSEC") issued an exposure�draft�of a proposed Stateriient of Position, "Accounting by. Producers and Distributors of Fil�ns" •�the ."SUP"). 'I1ie� pFOposed rules would establish new accounting standards for producers and distributors of films. �Amo�g its many:provisions, the SOP would require revenue for the licensing� of film and television product to be recognized generall� over the .term of the -related agreement. This would represent a significant change to existing industry pracdce, which generally requires such licensixg revenue to be recognized.when th�product is first. availahle. for telecast. This is because, after that date, licensors have no further significant obligations under the terms of the related licensing agreements. While the SOP's proposals in many other azeas (i.e., advertising and film cost amortization) generally are consistent with Time Warner's secounting poiicies, this is not the; case with the proposed changes in. revenue recognition for �licensed product. Adoptiag the� proposed accoundng standazds for licensed product would result in a.significant one-time, noncash �harge .to earnings upon adoption that would be reflected as a cumulative effect of a change in accounting principle. This one-time, noncash charge.would be reversed in future periods as an increase to operating income when Time Warner re-recognizes the revenues associated with the licensing of its film and television product over the periods of the related licensing agreements. The SOP proposes an effective date of January 1, 2000 for calendar year-end companies, with eazlier application encouraged. The provisions of the SOP are still being deliberated by AcSEC and could change significantly prior to the issuance of a final standard. Advertising In accordance with Financial Accounting Standards Board ("FASB") Statement No. 53, "Financial Reporting by Producers and Distributors of Motion Rcture Films," advertising costs for theatrical and television_ product are capitalized and amortized over the related revenue streams in each market that such costs are intended to benefit, which generally dces not exceed three months. Other advertising costs are expensed upon the first exhibition of the advertisement, except for certain direct-response advertising, for which the costs are capitalized and amortized over the expected period of future benefits. Direct-response advertising pcincipally consists of product promotional mailings, broadcast advertising, catalogs and other F-31 TIME WARNER INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS —(Continued) promotional costs incurred in the Company's direct-markering businesses. Deferred advertising costs are generally amortized over periods of up to three years subsequent to the promotional event using straight-line or accelerated methods, with a significant portion of such costs amortized in twelve mon�hs or less. Deferred advertising costs for Time Warner amounted to $282 million and $244 million at December 31, 1998 and 1997, respectively. Advertising expense, excluding theatrical and television product, amounted to $1.154 billion in 1998, $1.080 billion in 1997 and $1.050 billion in 1996. Cash and Equivalents Cash equivalents consist of commercial paper and other investments that are readily convertible into cash and have original maturities of three months or less. Financial Instruments' Effective July 1, 1998, Time Warner adopted FASB Statement No. 133, "Accounting for Derivative Instruments and Hedging Activities" ("FAS 133"). FAS 133 requires that all derivative financial instru- ments, such as interest rate swap contracts and foreign exchange contracts, be recognized in the financial statements and measured at fair value regardless of the purpose or intent for,holding them. Changes in the fair value of derivative financial instruments are either recognized periodically in income or. shareholders' equity (as a component of comprehensive income), depending on whether the derivative is being used to hedge changes in fair value or cash flows. The adoption of FAS 133 did not have a material effect on Time Warner's primary financial statements, but did reduce comprehensive income by $18 million in the accompanying consolidated statement of shareholders' equity. The carrying value of Time Warner's financial instruments approximates fair value, except for differences with respect to long-term, fixed-rate debt (Note 7) and certain differences relating to cost method investments and other financial instruments that are ,not significant. The fair value of financial instruments is generally determined by reference to market values resulting from trading on a national securities exchange or in an over-the-counter market. In cases where quoted market prices are not available; such as for derivative financial instruments, fair value is based on estimates using present value or other valuation techniques. Property, Plant and Equipment Property, plant and equipment are stated at cost. Additions to. cable property, plant and equipment generally include material, labor, overhead and interest. Depreciation is provided generally on the straight-line method over useful lives ranging up to thirty years for buildings and improvements and up to sixteen years for fumiture, fixtures, cable television and other equipment. Property, plant and equipment .consists of: December 31, 1998 1997 (millions) Land and buildings ....................................... $ 963 $ 962 Cable television equipment . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,035 941 Fumiture, fixtures and other equipment . . . . . . . . . . . . . . . . . . . . 1,400 1,337 3,398 3,240 Less accumulated depreciation . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,407) (1,151) Total ................................................... $ 1,991 $ 2,089 F-32 TIME WARNER INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS —(Continued) Intangible Assets As a creator and distributor of branded information and entertainment copyrights, Time Warner has a significant and growing number of intangible assets, including goodwill, cable television and sports franchises, film and television libraries, music catalogues, contracts and copyrights, and other copyrighted products and trademarks. In accordance with generally accepted accounting principles, Time Warner does not recognize the fair value of internally generated intangible assets. Costs incurred to create and produce copyrighted product, such as feature films, television series and compact discs, are generally either expensed as incurred, or capitalized as tangible assets as in the case of cash advances and inventoriable product costs. However, accounting recognition is not given to any increasing asset value that may be associated with the collection of the underlying copyrighted material. Additionally, costs incurred to create or extend brands, such as magazine titles, new television networks and Internet sites, generally result in losses over an extended development period and are recognized as a reduction of income as incurred, while any corresponding brand value created is not recognized as an intangible asset in the consolidated balance sheet. On the other hand, intangible assets acquired in business combinations accounted for by the purchase method of accounting are capitalized and amortized over their expected useful life as a noncash chazge against future results of operations. Accordingly, the intangible assets reported in the consolidated balance sheet do not reflect the fair value of Time Warner's intemally generated intangible assets, but rather are limited to intangible assets resulting from certain acquisitions in which the cost of the acquired companies exceeded the fair value of their tangible assets at the time of acquisition. Time Warner amortizes goodwill and sports franchises over periods up to forty years using the straight- line method. Cable television franchises, film and television libraries, music catalogues, contracts and copyrights, and other intangible assets are amortized over periods up to twenty years using the straight-line method. Amortization of intangible assets amounted to $800 million in 1998, $912 million in 1997 and $681 million in 1996. Accumulated amortization of intangible assets at December 31, 1998 and 1997 amounted to $3.9 billion and $3.181 billion, respectively. Time Warner periodically reviews the carrying value of acquired intangible assets for each acquired entity to determine whether an impairment may exist. Time Warner considers relevant cash flow and profitability information, including estimated future operating results, trends and other available information, in assessing whether the carrying value of intangible assets can be recovered. If it is determined that the carrying value of intangible assets will not be recovered from the undiscounted future cash flows of the acquired business, the carrying value of such intangible assets would be considered impaired and reduced by a charge to operations in the aznount of the impairment. An impairment charge is measured as any deficiency in the amount of estimated undiscounted future cash flows of the acquired business available to recover the carrying value related to the intangible assets. Income Taxes Income taxes are provided using the liability method prescribed by FASB Statement No. 109, "Accounting for Income Taxes." Under the liability method, deferred income taxes reflect tax carryforwards and the net tax effects of temporary differences between the carrying amount of assets and liabilities for financial statement and income tax purposes, as determined under enacted tax laws and rates. The financial effect of changes in tax laws or rates is accounted for in the period of enactment. The subsequent realization of net operating loss and investment tax credit cariyforwards acquired in acquisitions are accounted for as a reduction of goodwill. The principal operations of the Entertainment Group are conducted by partnerships. Income tax expense includes all income taxes related to Time Warner's allocable share of partnership income and its equity in the income tax expense of corporate subsidiaries of the partnerships. F-33 TIME WARNER INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS —(Continued) Stock Options In accordance with Accounting Principles Board Opinion No. 25, "Accounting for Stock Issued to Employees" ("APB 25"), compensation cost for stock options is recognized in income based on the excess, if any, of the quoted market price of the stock at the grant date of the award or other measurement date over the amount an employee must pay to acquire the stock. Generally, the exercise price for stock options granted to employees equals or exceeds the fair market value of Time Warner common stock at the date of grant, thereby resulting in no recognition of compensation expense by Time Warner. Loss Per Common Share Effective December 31, 1997, Time Warner adopted FASB Statement No. 128, "Earnings per Share" ("FAS 128"), which established simplified standards for computing and presenting earnings per share information. The adoption of FAS 128 did not have any effect on Time Warner's financial statements. Basic loss per common share is computed by dividing the net loss applicable to common shares after preferred dividend requirements by the weighted average of common shares outstanding during the period. Diluted loss per common share adjusts basic loss per common share for the effects of convertible securities, stock options and other potentially dilutive financial instruments, only in the periods in which such effect is dilutive. Such effect was not dilutive in any of the periods presented herein: Comprehensive Income Effective January 1, 1997, Time Warner adopted FASB Statement No. 130, "Reparting Comprehensive Income" ("FAS 130'.'). The new rules established standazds for the reporting of comprehensive income and its components in financial statements. Comprehensive income consists of net income and other gains and losses affecting shareholders' equity that, under generally accepted accounting principles, are excluded from net income. For Time Warner, such items consist primarily of unrealized gains artd losses on marketable equity investments, gains and losses on certain derivative financial instruments and foreign currency translarion gains and losses. The adoption of FAS 130 did not have a material effect on Time Warner's primary financial statements, but did affect the presentation of the accornpanying consolidated statement of shareholders' equity. The following summary sets forth the components of other comprehensive income (loss) accumulated in shareholders' equity: Accumulated Foreign Derivative Other Unrealized Currency Financial Comprehensive Gains on Translation Instrument Income Securities Gains (Losses) Losses (L.oss) (millions) Balance at December 31, 1997 . . . . . . . $5 1998 activity . . . . . . . . . . . . . . . . . . . . . . — Balance at December 31, 1998 . . . . . . . $5 Segment Information $(87) $ — $ (82) 4 �) (34) $(83) $S38) $(116) On December 31, 1997, Time Wamer adopted FASB Statement No. 131, "Disclosures about Segments of an Enterprise and Related Information" ("FAS 131"). The new rules established revised standards for public companies relating to the reporting of financial and descriptive information about their operating segments in financial statements. The adoption of FAS 131 did not have a material effect on Time Warner's primary financial statements, but did affect the disclosure of segment information contained elsewhere herein (Note 16). F-34 TIME WARNER INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS —(Continued) 2. CABLE TRANSAGTIONS In addition to continuing to use cable operating cash flow to finance the level of capital spending necessary to upgrade the technological capability of cable television systems and develop new services, Time Warner, TWE and the TWE-Advance/Newhouse Partnership ("TWE-A/N") completed a series of transactions in 1998. These transactions related to the cable television business and related ancillary businesses that either reduced existing debt and/or Time Warner's and TWE's share of future funding requirements for such businesses. These transactions and a cable-related acquisition of Cablevision Industries Corporation and related companies ("CVI") in 1996 are discussed more fully below. TCI Cable Transactions During 1998, Time Warner, TWE, TWE-A/N and TCI Communications, Inc. ("TCI"), a subsidiary of Tele-Communications, Inc., consummated or agreed to complete a number of cable-related transactions. These transactions consisted of (i) the formation in December 1998 of a cable television joint venture in Texas (the "Texas Cable Joint Venture") that is managed by Time Warner Cable, a division of TWE, and owns cable television systems serving an aggregate 1.1 million subscribers, subject to approximately $1.3 billion of debt, (ii) the expansion in August 1998 of an existing joint venture in Kansas City, which is managed by Time Warner Cable, through the contribution by TCI of a contiguous cable television system serving approximately 95,000 subscribers, subject to approximately $200 million of debt and (iii) the agreement to exchange in 1999 various cable television systems serving approximately 575,000 subscribers for other cable television systems of comparable size in an effort to enhance each company's geographic clusters of cable television properties (the "TCI Cable Trades"). The Texas and Kansas City joint ventures are being aecounted for under the equity method of accounting. As a result of the Texas transaction, the combined debt of Time Warner and TWE was reduced by approximately $650 million. Also, as a result of the Texas and Kansas City transactions, Time Wamer and TWE benefited from the geographic clustering of cable television systems and the number of subscribers under the management of Time Warner Cable was increased by approximately 660,000 subscribers, thereby making Time Warner Cable the largest cable television operator in the U.S. The TCI Cable Trades are expected to close periodically throughout 1999 and are subject to customary closing conditions, including all necessary governmental and regulatory approvals. There can be no assurance that such approvals will be obtained. . Time Wamer Telecom Reorganization In July 1998, in an effort to combine their business telephony operations into a single entity that is intended to be self-financing, Time Warner, TWE and TWE-A/N completed a reorganization of their business telephony operations (the "Time Warner Telecom Reorganization") whereby (i) those operations conducted by Time Warner, TWE and 1"WE-A/N were each contributed to a new holding company named Time Warner Telecom LLC ("Time Warner Telecom"), and then (ii) TWE's and TWE-A/N's interests in Time Warner Telecom were distributed to their partners, Time Warner, MediaOne and the Advance/ Newhouse Partnership ("Advance/Newhouse"), a limited partner in TWE-A/N. As a result of the Time Warner Telecom Reorganization, Time Warner, MediaOne and Advance/Newhouse own interests in Time Warner Telecom of 61.9890, 18.85% and 19.17%, respectively. Time Warner's interest in Time Warner Telecom is being accounted for under the equity method of accounting because of certain approval rights held by MediaOne and Advance/Newhouse. Time Warner Telecom is a competitive local exchange carrier (CLEC) in selected metropolitan areas across the United States where it offers a wide range of telephony services to business customers. Following the Time Warner Telecom Reorganization, Time Warner Telecom raised approximately $400 million of cash in July 1998 through the issuance of public notes that mature in 2008. Such notes are non-recourse to Time F-35 TIME WARNER INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS —(Continued) Warner and the proceeds are being used by Time Warner Telecom to expand and further develop its telephony networks and services. In January 1999, Time Warner Telecom updated a previously filed, preliminary registration statement with the Securities and Exchange Gommission to conduct an initial public offering of a minority interest of its common stock (the "Time Warner Telecom IPO"). The Time Warner Telecom IPO was previously postponed when the IPO market deteriorated and remains subject to market and other conditions. There can be no assurance that it will be completed. Road Runner Joint Venture In June 1998, Time Warner, TWE, TWE-A/N, MediaOne, Microsoft Corp. ("Microsoft") and Compaq Computer Corp. ("Compaq") formed a joint venture to operate and expand Time Warner Cable's and MediaOne's e�cisting high-speed online businesses (the "Road Runner Joint Venture"). In exchange for contributing these operations, Time Warner received a common equity interest in the Road Runner Joint Venture of 10.7%, TWE received a 25% interest, TWE-A/N received a 32.9% interest and MediaOne received a 31.4% interest. In exchange for Microsoft and Compaq contributing $425 million of cash to the Road Runner Joint Venture, Microsoft and Compaq each received a preferred equity interest therein that is convertible into a 10% common equity interest. Accordingly, on a fully diluted basis, the Road Runner Joint Venture is owned 8.6% by Time Warner, 20% by TWE, 26.3% by TWE-A/N, 25.1% by MediaOne, 10% by Microsoft and 10% by Compaq. Each of Time Warner's, TWE's and TWE-A/N's interest in the Road Runner Joint Venture is being accounted for under the equity method of accounting. The aggregate $425 million of capital contributed by Microsoft and Compaq is being used by the Road Runner Joint Venture to conrinue to expand the roll out of high-speed online services. Time Warner Cable has entered into an afliliation agreement with the Road Runner Joint Venture, pursuant to which Time Warner Cable provides Road Runner's high-speed online services to customers in its cable franchise areas through its technologically advanced, high-capacity cable architecture. In exchange, Time Warner Cable initially retains 70% of the subscription revenues and 30% of the national advertising and transactional revenues generated from the delivery of these online services to its cable subscribers. Time Wamer Cable's share of these subscription revenues will change periodically to 75% by 2006. Primestar In April 1998, TWE and Advance/Newhouse transferred the direct broadcast satellite operations conducted by TWE and TWE-A/N (the "DBS Operations") and the 31�'o partnership interest in Primestar Partners, L.P. held by TWE-A/N ("Primestar Partners" and collectively, the "Primestar Assets") to Primestaz, Inc. ("Primestar"), a separate holding company. As a result of that transfer and similar transfers by the other previously existing partners of Primestar Partners, Primestar Partners became an indirect wholly owned subsidiary of Primestar. In exchange for contributing its interests in the Primestar Assets, TWE received approximately 48 million shares of Primestar common stock (representing an approximate 24% equity interest) and realized approximately $240 million of debt reduction. In partial consideration for contributing its indirect interest in certain of the Primestar Assets, Advance/Newhouse received an approximate 6% equity interest in Primestar. As a result of this transaction, effective as of April 1, 1998, TWE deconsolidated the DBS Operations and the 24% equity interest in Primestar received in the transaction is being accounted for under the equity method of accounting. This transaction is referred to as the "Primestar Roll-up Transaction." In connection with the Primestar Roll-up Transaction, Primestar and Primestar Partners own and operate the medium-power direct broadcast satellite business, portions of which were formerly owned by TCI Satellite Entertainment, Inc. ("TSAT") and the other previously existing partners of Primestar Partners. Certain high- power system assets, including two high-power satellites, continue to be owned by Tempo Satellite, Inc. F-36 TIME WARNER INC. NOTES TO CONSOLIDATED FINANCIAL STAT'EMENT'S —(Continued) ("Tempo"), a wholly owned subsidiary of TSAT. However, Primestar Partners has an option to lease or purchase the entire capacity of the high-power system from Tempo. In addition, Primestar has an option to purchase the stock or assets of Tempo from TSAT. In a related transaction, Primestar Partners also entered into an agreement in June 1997 with The News Corporation Limited ("News Corp."), MCI WorldCom, Inc. ("MCI") and American Sky Broadcasting LLC ("ASkyB"), pursuant to which Primestar would acquire certain assets relating to the high-power, direct broadcast satellite business of ASkyB (the "Primestar ASkyB Transaction"). In May 1998, the U.S. Department of Justice brought a civil action against Primestar, each of its cable owners, including TWE, and News Corp. and MCI, to enjoin on antitrust grounds the Primestar ASkyB Transaction. Although the parties had discussions with the U.S. Department of Justice in an attempt to restructure the transaction, no resolution was reached and the parties terminated their agreement in October 1998. In the fourth quarter of 1998, TWE recorded a charge of approximately $210 million principally to reduce the carrying value of its interest in Primestar. This charge reflected a significant decline in the fair value of Primestar during the quarter and has been included in interest and other, net, in TWE's 1998 consolidated statement of operations. In addition, Primestar, Primestar Partners and the stockholders of Primestar have entered into an agreement to sell the medium-power direct broadcast satellite business and assets to D'uecl"V, a competitor of Primestar owned by Hughes Electronics Corp. Also, Primestar, Primestar Partners, the stockholders of Primestar and Tempo entered into a second agreement with DirecTV, pursuant to which DirecTV will purchase the high-power satellites from Tempo, and Primestar and Primestar Partners will relinquish their respective rights to acquire or use such high-power satellites. The price to be paid by DirecTV pursuant to these agreements confirmed the decline in value of TWE's interest in Primestar. The ultimate disposition of the medium-power assets of Primestar is subject to Primestar bondholder and regulatory approvals, and the disposition of certain of the high-power satellite rights is also subject to regulatory approvals. Accordingly, there can be no assurance that such approvals will be obtained and that these transactions will be consummated. TWE-A/N Transfers As of December 31, 1998, TWE-A/N owned cable television systems (or interests therein) serving approximately 6.3 million subscribers, of which 5.2 million subscribers were served by consolidated, wholly owned cable television systems and 1.1 million subscribers were served by unconsolidated, partially owned cable television systems. TWE-A/N had approximately $1.2 billion of debt at December 31, 1998. TWE-A/N is owned approximately 64.83'o by TWE, the managing partner, 33.3°Io by Advance/ Newhouse and 1.9�o indirectly by Time Warner. TWE consolidates the partnership, and the partnership interests owned by Advance/Newhouse and Time Warner are reflected in 'TWE's consolidated financial statements as minority interest. In accordance with the partnership agreement, Advance/Newhouse can require TWE to purchase its equity interest for fair market value at specified intervals following the death of both of its principal shareholders. In addition, TWE or Advance/Newhouse can initiate a restructuring of the partnership, in which Advance/Newhouse would withdraw from the partnership and receive one-third of the partnership's net assets. In early 1998, Time Wamer (through a wholly owned subsidiary) contributed cable television systems (or interests therein) serving approximately 650,000 subscribers to I'WE-A/N, subject to approximately $I billion of debt, in exchange for common and preferred parmership interests in TWE-A/N, and completed certain related transacrions (collectively, the "TWE-A/N Transfers"). 1'he cable television systems trans- ferred to TWE-A/N were formerly owned by TWI Cable Inc. ("TWI Cable"), a wholly owned subsidiary of Time Warner, and Paragon Communications ("Paragon"), a partnership formerly owning cable television systems serving approximately 1 million subscribers that was wholly owned by subsidiaries of Time Warner, F-37 TIME WARNER INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS —(Continued) with 50°Io beneficially owned in the aggregate by 1'WE and TWE-A/N. The debt assumed by TWE-A/N has been guaranteed by TWI Cable and certain of its subsidiaries, including Paragon. As part of the TWE-A/N Transfers, TWE and TWE-A/N exchanged substantially all of their respective beneficial interests in Paragon for an equivalent share of Paragon's cable television systems (or interests therein) serving approximately 500,000 subscribers, resulring in wholly owned subsidiaries of Time Warner owning 100% of the restructured Paragon entity, with less than 1% beneficially held for TWE. Accordingly, effective as of January 1, 1998, Time Warner has consolidated Paragon. Because this transaction represented an exchange of TWE's and TWE-A/N's beneficial interests in Paragon for an equivalent amount of its cable television systems, it did not have a significant economic impact on Time Warner, TWE or TWE-A/N. The TWE-A/N Transfers were accounted for effective as of January 1, 1998. Time Warner did not recognize a gain or loss on the TWE-A/N Transfers. TWE has continued to consolidate TWE-A/N and Time Warner has accounted for its interest in TWE-A/N under the equity method of accounting. On a pro forma basis, giving effect to the TWE-A/N Transfers as if they had occurred at the beginning of 1997, Time Warner would have reported for the year ended December 31, 1997 revenues of $13.233 billion, depreciation expense of $375 million, operating income before noncash amortization of intangible assets of $2.068 billion, operating income of $1.219 billion, equity in the pretax income of the Entertainment Group of $679 million, income before extraordinary item of $307 million ($.O1 loss per common share) and net income of $252 million ($.06 loss per common share). CVI Acquisition On January 4, 1996, Time Warner acquired CVI, which owned cable television systems serving approximately 1.3 million subscribers, in exchange for the issuance of approximately 5.8 million shares of common stock and approximately 6.3 million shares of new convertible preferred stock ("Series E Preferred Stock" and "Series F Preferred Stock") and the assumption or incurrence of approximately $2 billion of indebtedness. The acquisition was accounted for by the purchase method of accounting for business combinations; accordingly, the cost to acquire CVI of $904 million was allocated to the net assets acquired in proportion to their respective fair values, as follows: cable television franchises-$2.390 billion; goodwill-$688 million; other cunent and noncurrent assets-$481 million; long-term debt-$1.766 billion; deferred income taxes-$731 million; and other current and noncurrent liabilities-$158 million. In October 1996, Time Warner reorganized the legal ownership of its wholly owned cable subsidiaries, whereby the equity ownership of its other wholly owned cable subsidiaries was contributed to CVI. In connection therewith, CVI was renamed T'WI Cable Inc. 3. TBS TRANSACTION On October 10, 1996, Time Warner acquired the remaining 80°k interest in TBS that it did not already own (the "TBS Transaction"). As part of the transacrion; each of TW Companies and TBS became a separate, wholly owned subsidiary of Time Warner which combines, for financial reporting purposes, the consolidated net assets and operating results of TW Companies and TBS. Each issued and outstanding share of each class of capital stock of TW Companies was converted into one share of a substantially identical class of capital stock of Time Warner. In connection with the TBS Transaction, Time Warner issued (i) approximately 359.6 million shares of common stock (including 114.2 million equivalent shares of common stock in the form of a special class of non-redeemable common stock ("Series LMCN-V Common Stock") to affiliates of Liberty Media Corpora- tion ("LMC"), a subsidiary of Tele-Communications, Inc.), in exchange for shares of TBS capital stock and pursuant to a separate oprion agreement with LMC and its affiliates (the "SSSI Option Agreement") and F-38 TIME WARNER INC. NOTES TO CONSOLIDATED FIlVANCIAL STATEMENTS —(Continued) (ii) approximately 28 million stock options to replace all outstanding TBS stock options. Time Warner also assumed approximately $2.8 billion of indebtedness. Of the aggregate consideration issued in the TBS Transaction, 12.8 million equivalent shares of common stock in the form of Series LMCN-V Common Stock were issued to LIvIC and its affiliates in June 1997 pursuant to the SSSI Option Agreement. The SSSI Option Agreement enabled Time Wamer to acquire substantially all of the assets of Southem Satellite Systems, Inc. and its affiliates ("SSSI"), a subsidiary of LMC that formerly provided uplink and distribution services for WTBS (the "TBS Superstation"), for approximately $213 million effective as of December 31, 1997, the date on which the TBS Superstation was converted to a copyright-paid, cable television programming service. The TBS Transaction was accounted for by the purchase method of accounting for business combinations; accordingly, the cost to acquire TBS of approximately $6.2 billion was allocated to the net assets acquired in proportion to their respective fair values, as follows: goodwill-$6.842 billion; other current and noncurrent assets-$3.624 billion; long-term debt-$2.765 billion; deferred income taxes-$117 million; and other current and noncuaent liabilities-$1.410 billion. 4. ENTERTAINMENT GROUP Time Warner's investment in and amounts due to and from the Entertainment Group at December 31, 1998 and 1997 consists of the following: Investmentin TWE ................................................. Stock option related distriburions due from TWE . . . . . . . . . . . . . . . . . . . . . . . . Credit agreement debt due to TWE . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Other net amounts due to TWE, principally related to home video distribution ...................................................... December 31, 1998 1997 (millions) $3,850 $5,577 1,130 417 (400) (400) (395) 141) Investment in and amounts due to and from TWE . . . . . . . . . . . . . . . . . . . . . . . 4,185 Investment in TWE-A/N and other Entertainment Group companies ....... 795 Total............................................................. $4,980 Partnership Structure 5,453 96 $5,549 TWE is a Delawaze limited partnership that was capitalized on June 30, 1992 to own and operate substantially all of the Filmed Entertainment-Warner Bros., Cable Networks-HBO and Cable businesses previously owned by subsidiaries of Time Warner. Certain Time Warner subsidiaries are the general partners of TWE ("Time Warner General Partners"). Time Warner, through its wholly owned subsidiaries, collectively owns general and limited partnership interests in TWE consisting of 74.4996 of the Series A Capital and Residual Capital and 100% of the Senior Capital and Series B Capital. The remaining 25.51°!b limited partnership interests in the Series A Capital and Residual Capital of TWE are owned by MediaOne, which acquired such interests in 1993 for $1.532 billion of cash and a$1.021 billion 4.4°90 note (the "MediaOne Note Receivable") that was fully collected during 1996. Partnership Capital and Allocation of Income Each partner's interest in TWE generally consists of the undistributed priority capital and residual equity amounts that were initially assigned to that partner or its predecessor based on the estimated fair value of the net assets each contributed to TWE ("Undistributed Contributed Capital"), plus, with respect to the priority F-39 TIME WARNER INC. NOTES TO CONSOLIDATED FINANCIAL STA7'EMENTS —(Continued) capital interests only, any undistributed priority capital return. The priority capital return consists of net partnership income allocated to date in accordance with the provisions of the TWE partnership agreement and the right to be allocated additional partnership income which, together, provides for the various priority capital rates of return as specified in the table below. The sum of Undistributed Contributed Capital and the undistributed priority capital return is referred to herein as "Cumulative Priority Capital." Cumulative Priority Capital is not necessarily indicative of the fair value of the underlying priority capital interests principally due to above-market rates of return on certain priority capital interests as compared to securities of comparable credit risk and maturity, such as the 13.25% rate of return on the Series B Capital interest owned by the Time Warner General Partners. Furthermore, the ultimate realization of Cumulative Priority Capital could be affected by the fair value of TWE, which is subject to fluctuation. A summary of the priority of Undistributed Contributed Capital, ?ime Warner's ownership of Undistrib- uted Contributed Capital and Cumulative Priority Capital at December 31, 1998 and priority capital rates of return thereon is as set forth below: Undistributed Cumulative Contributed Priority Priority of Undistributed Contributed Capital Capital(a) Capital (billions) Senior Capital . . . . . . . . . . . . . . . . . . . $0.5 $ 0.6 Series A Capital . . . . . . . . . . . . . . . . . 5.6 12.8 Series B Capital . . . . . . . . . . . . . . . . . 2.9�d� 6.8 Residual Capital . . . . . . . . . . . . . . . . . 3.3�d� 3.3�`� Priority Capital Rates of Return (b) 8.00% 13.00% 13.25% _�� % Owned by Time Warner 100.00% 74.49% 100.00% 74.49% (a) Excludes partnership income or loss allocated thereto. (b) To the extent income allocations are concurrently distributed, the priority capital rates of return on the Series A Capital and Series B Capital are 1 l% and I 1.25%, respectively. (c) Rosidual Capital is not entitled to stated priority rates of return dnd, as such, its Cumulative Priority Capital is equal to its Undistributed Contributed Capital. However, in the case of certain events such as the liquidation or dissolution of TWE, Residua] Capital is entitled to any exeess of the then fxir value of the net assets of'CWE over the aggregate amount of Cumulative Priority Capital and special tax allocations. (d) The Undistributed Contributed Capital relating to the Series B Capital has priority over the priority returns on the Series A Capital. 7'he Undistributed Contributed Capital relating to the Residual Capital has priority over the priority returns on the Series B Capital and the Series A Capital. Because Undistributed Contributed Capital is generally based on the fair value of the net assets that each partner inirially contributed to the partnership, the aggregate of such amounts is significantly higher than TWE's partners' capital as reflected in the consolidated financial statements, which is based on the historical cost of the contributed net assets. For purposes of allocating partnership income or loss to the partners, partnership income or loss is based on the fair value of the net assets contributed to the partnership and results in significantly less partnership income, or results in partnership losses, in contrast to the net income reported by TWE for financial statement purposes, which is also based on the historical cost of contributed net assets. Under the TWE partnership agreement, partnership income, to the extent earned, is first allocated to the partners' capital accounts so that the economic burden of the income tax consec}uences of partnership operations is borne as though the partnership were taxed as a corporation ("special tax allocations"). After any special tax allocations, partnership income is allocated to the Senior Capital, Series A Capital and Series B Capital, in order of priority, at rates of return ranging from 8% to 13.25% per annum, and finally to the Residual Capital. Partnership losses generally are allocated first to eliminate prior allocations of partnership income to, and then to reduce the Undistributed Contributed Capital of, the Residual Capital, Series B Capital and Series A Capital, in that order, then to reduce the Time Warner General Partners' Senior Capital, including partnership income allocated thereto, and finally to reduce any special tax allocations. To F-40 TIME WARNER INC. NOTES TO CONSOLIDATED FINAIV.CIAL STATEMENTS —(Continued) the extent partnership income is insufiicient to satisfy a11 special allocations in a particular accounting period, the right to receive additional partnership income necessary to provide for the various priority capital rates of return is carried forward until satisfied out of future partnership income, including any partnership income that may result from any liquidation, sale or dissolution of TWE. TWE reported net income of $326 million, $614 million and $210 million in 1998, 1997 and 1996, respecrively, no portion of which was allocated to the limited partners. The Series B Capital owned by the Time Warner General Partners may be increased if certain operating performance targets aze achieved over a ten-year period ending on December 31, 2001, although it does not appear likely at this time that such targets wiU be achieved. In addition, MediaOne has an option to obtain up to an additional 633% of Series A Capital and Residual Capital interests, depending on cable operating performance. The option is exercisable at any time through May 2005 at a maximum exercise price of $1.25 billion to $1.8 billion, depending on the year of exercise. Either MediaOne or TWE may elect that the exercise price be paid with partnership interests rather than cash. Summarized Financial Information of the Entertainment Group Set forth below is summarized financial information of the Entertainment Group, which reflects the TWE-A/N Transfers effective as of January 1, 1998, the Primestar Roll-up Transaction effective as of April 1, 1998, the formation of the Road Runner Joint Venture ef%ctive as of June 30, 1998 and the Time Warner Telecom Reorganization effective as of July 1, 1998. Years Ended December 31, 1998 1997 1996 (millions) Operating Statement Information Revenues ............................................. $12,256 Depreciation and amortization . . . . . . . . . . . . . . . . . . . . . . . . . . . . Business segment operating income�'� . . . . .. . . . . . .. .. . . . . . . Interest and other, net�2� . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Minority interest . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Income before income taxes . . . . . . . . . . . . . . . . . . . . . . . . . . Income before extraordinary item . . . . . . . . . . . . . . . . . . . . . . . . . Netincome ............................................ (1,436) 1,724 (965) (264) 423 331 331 $11,328 (1,386) 1,461 (357) (305) 727 642 619 $10,861 � 1.244) 1,090 (524) (207) 290 220 220 (1) Includes net preta�� gains of approximatcly $90 million in 1998 and $200 million in 1997 related to the sale or exchange of certain cable television systems. (2) Includes a charge of approximately $210 million in 1998 principally to reduce the carrying value of an interest in Primestar. 1997 includes a gain of approximately $250 million rclated to the sale of an interest in E! Entertainment Television, Inc. ("E! Entertainment"). F-41 TIME WARNER INC. NOTES TO CONSOLIDATED FiNANCIAL STATEMENTS —(Continued) Cash Flow Information Cash provided by operations ....... ....................:. Capital expenditures .................................... Investments and acquisitions .. . . . . . . . . . . _, Investment proceeds . . . . . � . . . . . . . . . . . . Borrowings . . . . . . . � . . . . . � . . . . . . . . . .. . . . . Debt repayments ........ .......... .................. Issuance of preferred stock of subsidiary . . . . . . . . . . . . . . . . . Collections on nvte receivable from MediaOne . ..: . . . . . . . . . . . Capital distributions . . . . . . . . . .. . . . . . . . . . . . . . . . . . . . . . . . . . Other financing activides, net . . . . . . . . . . . . . . . . . . . . . . . . . . . . Increase (decrease) in cash and equivaients . . .' . . . . . :. . . . . . . Yesrs Ended December 31, 1998 ' 1997 1996 (millions) $ 2,288 $ 1,799 $ 1,912 (1,603) (1,565) (1,719) (388) (172) (146) 1,246 520 612 1,514 3,400 215 (1,898) (3,085) (7I6) — 243 — (1,153) (241) (235) Balance Sheet Information Cash and equivalents .............................................. Total current�assets ............................................... Total assets ...................................................... Total current liabilities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Long-term debt ................................................ Minority interests ..... . . ........... ........ ....... .. ... ......�. . ,Preferred stock ofsubsidiary ........................................ Time Warner General Partners' Senior Capital . . . . . . . . . . ... . . . . . . . . . . . . Partners' capital ........ . ....... ............................... Capital Distributions . . — 169 (934) (228) (100) (92) 106 7 December 31, 1998 1997 (millions) $ 87 4,187 22,241 4,940 6,578 1,522 217 603 5,210 $ 322 3,623 20,739 3,976 5,990 1,210 233 1,118 6,430 The assets and cash flows of TWE are restricted by the TWE partnership and credit agreements and are unavailable for use by the partners except through the payment of certain fees, reimbursements, cash distributions and loans, which are subject to limitarions. - The Time Warner General Partners.: received $579 million .and $535 million in 1998 and 1997, ;;,spectively, of distributions from TWE relating to then' Senior Capital interests, thereby increasing the cumulative cash distributions received from TWE on such interests to $1.5 billion. The Time Wamer General Partners' remaining $603 million Senior Capital interests and any undistributed partnership income allocated thereto (based on an 8% annual rate of retum) are required to be distributed on July 1, 1999. At December 31, 1998 and 1997, the Time Warner General Partners had recorded $1.130 billion and $417 million, respectively, of stock option related distributions due from TWE, based on closing prices of Time Warner common stock of $62.06 and $31.00, respectively. Time Warner is paid when the options are exercised. The Time Warner General Partners also receive tax-related distributions from TWE on a current basis. During 1998, the Time Warner General Partners received distributions from TWE in the amount of $1.153 billion, consisting of $579 million of Senior Capital distributions (representing the return of $455 million of contributed capital and the distribution of $124 million of priority capital return), $314 million of tax-related distributions and $260 million of stock option related distributions. During 1997, the Time Warner General Partners received distributions from TWE in the amount of $934 million, consisting of $535 million of F-42 TIME WARNER INC. NOTES TO CONSOLIDATED F.INANCIAL STATEMENTS —(Continued) Senior Capital distributions (representing the return of $455 million of contributed capital and the distribution of $80 million of priority capital return), $324 million of tax-related distributions and $75 million of stock option related distributions. During 1996, the Time Warner General Partners received distributions from TWE in the amount of $228 million, consisting of $215 million of tax-related distributions and $13 million of stock option related distributions. In addition to the tax, stock option and Time Warner General Partners' Senior Capital distributions, TWE may make other capital distributions to its partners that are also subject to certain limitations contained in the TWE partnership and credit agreements. In addition, in connection with the Time Warner Telecom Reorganization, TWE made a$191 million noncash distribution to its partners, of which certain wholly owned subsidiaries of Time Warner received an interest in Time Warner Telecom recorded at $143 million based on TWE's historical cost of the net assets (Note 2). Debt Guarantees Each Time Warner General Partner has guaranteed a pro rata portion of approximately $5.5 billion of TWE's debt and accrued interest at December 31, 1998, based on the relative fair value of the net assets each Time Wamer General Partner (or its predecessor) contributed to TWE. Such indebtedness is recourse to each Time Warner General Partner only to the extent of its guarantee. There aze no restrictions on the ability of the Time Warner General Partner guarantors to transfer assets, other than TWE assets, to parties that are not guarantors. In addition, in connection with the TWE-A/N Transfers (Note 2), approximately $1.2 billion of TWE-A/N's debt and accrued interest at December 31, 1998 has been guaranteed by TWI Cable and certain of its subsidiaries. Six Flags In April 1998, TWE sold its remaining 49% interest in Six Flags Entertainment Corporation. ("Six Flags") to Premier Parks Inc. ("Premier"), a regional theme park operator, for approximately $475 million of cash. TWE used the net, after-tax proceeds from this transaction to reduce debt by approximately $300 million. As part of the transaction, TWE will continue to license its animated cartoon and comic book characters to Six Flags's theme parks and will similarly license such rights to Premier's theme parks in the United States and Canada under a long-term agreement covering an aggregate of twenty-five existing and all future locations. A substantial portion of the gain on this transaction has been deferred by TWE, principally as a result of uncertainties surrounding realization that relate to ongoing litigation and TWE's continuing guarantees of certain significant long-term obligations associated with the Six Flags Over Texas and Six Flags Over Georgia theme parks. 5. OTHER INVESTMENTS Time Warner's other investments consist of: Equity method investments . . . . . . . . . . . . . . . . . . Cost and fair-value method investments . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Total............................................................... Deeember 3l, 1998 1997 (millions) $483 $1,350 311 145 $794 $1,495 In addition to TWE and its equity investees, compaaies accounted for using the equity method include: Time Warner Telecom (62% owned), the Columbia House Company partnerships (509'0 owned), other music joint ventures (generally 503'0 owned) and Cinamerica Theatres, L.P. (sold in 1997, but previously 50% F-43 TIME WARNER INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS —(Continued) owned). A summary of combined financial information as reported by the equity investees of Time Warner is set forth below: Years Ended December 31, 1998 1997 1996 (millions) Revenues ................................................ Depreciation and amortiZation ............................... Operating income (loss) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Net income (loss) . . . . . . . .. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Current assets ............................................ Totalassets ......................,....................... Current liabilities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Long-term debt ........................................... Total liabilities ............................................ Total shareholders' deficit or partners' capital . . . . . . . . . . . . . . . . . . $1,275 (43) (1) (109) 1,183 2;065 587 1,807 2,464 (399) $1,336 (13) 80 (36) 792 1,132 418 1,303 1,791 (659) $1,773 (29) 173 61 1,002 1,616 517 1,360 1,999 (383) In addition to the equity investees listed above, TWE's equity investees at December 31, 1998 included: Comedy Partners, L.P. (50% owned), certain cable television system joint ventures (generally 50% owned), the Road Runner Joint Venture (57.9% owned, excluding Time Warner's direct 10.7% interest), Primestar (24% owned), Six Flags (49% owned in 1997 and 1996), certain intemational cable and programming joint ventures (25% to 50°l0 owned) and Courtroom Television Network (50°l0 owned). A summary of combined financial information as reported by the equity investees of TWE is set forth below: Years Ended December 31, 1998 1997 1996 (millions) Revenues ................................................ Depreciarion and amortization . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Operating income (loss) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Netloss................................................. Current assets ........................................:... Total assets .............................................. Current liabilities . . : . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Long-tertn debt ........................................... Totalliabilities ............................................ Total shareholders' equity or partners' capital . . . . . . . . . . . . . . . . . . $2,329 (706) (2�5) (352) 665 5,228 628 2,917 3,699 1,529 $2,207 (235) 118 i82) 412 3,046 993 1,625 2,734 312 $1,823 (197) 62 (138) 624 3,193 407 2,197 2,829 364 Included in the foregoing summary is combined financial information of Time Warner Cable's unconsolidated cable television systems that serve an aggregate of 2.3 million subscribers as of December 31, 1998. Time Warner Cable has an approximate 50% weighted-average interest in these cable television systems. For 1998, excluding the operating results of the Texas Cable Joint Venture which was formed at the end of the year, these cable television systems reported combined operating income of $93 million and combined depreciation and amortization of $160 million. Similarly, at the end of 1998, including approxi- mately. $1.3 billion of debt of the Texas Cable Joint Venture, these cable television systems had debt of approximately $2.4 billion. F-44 TIME WARNER INC. NOTES TO CONSOLmATED FINANCIAL STATEMENTS —(Continued) 6. IN VENTORIES Inventories consist of: Film costs: Released, less amortization . . . . . . . . . . . . . . . . . . Completed and not released . . . . . . . . . . . . . . . . . In process and other ....................... Library, less amortization . . . . . . . . . . . . . . . . . . . Programming costs, less amortization . . . . . . . . . . , Magazines, books and recorded music . . . . . . . . . . Total...................................... December 31, 1998 December 31, 1997 Curreat Noncurrent Current Noncurrent (millions) $ 51 $ 308 20 — 2 240 — 1,007 457 345 416 — $946 $1,900 $ 68 $ 228 88 48 — 141 — 1,064 293 285 381 — $830 $1,766 Excluding the Library, the total cost incurred in the production of theatrical and television product (including direct production costs, producrion overhead and certain exploitation costs, such as film prints and home videocassettes) amounted to $633 million in 1998 and $506 million in 1997; and the total cost amortized amounted to $585 million and $613 million, respectively. Excluding the Library, the unamortized cost of completed films at December 31, 1998 amounted to $379 million, approximately 90% of which is expected to be amortized within three years after release. 7. LONG-TERM DEBT Long-term debt consists of: Weighted-Arerage Interest Rate at December 31, 1998 Bank credit agreement borrowings ...... 6.(�3'0 Fixed-rate senior notes and debentures ... 7.896 Variable-rate senior notes . . . . . . . . . . . . . . 4.8% Zeracoupon convertible notes . . . . . . . . . . — Total............................... Maturiti� 2002 2000-2036 2009-2031 December 31, 1998 1997 (millions) $ 1,234 $ 2,600 8,491 6,909 1,200 1,200 — 1,124 $10,925 $11,833 Substantially all of Time Warner's long-term debt represents the obligations of its wholly owned subsidiaries TW Companies, TBS and TWI Cable. Time Warner and each of TW Companies and TBS (the "Guarantor Subsidiaries") have fully and unconditionally guaranteed any outstanding .publicly traded indebtedness of each other and, along with TWI Cable, have similarly guaranteed each other's outstanding borrowings under iheir joint bank credit agreement. As a result, the credit profile associated with the indebtedness of Time Warner or any of the Guarantor Subsidiaries is substantially the same. Financing Activities During the past three years, in response to favorable mazket condirions and in connection with certain acquisitions, Time Warner and its consolidated subsidiaries have refinanced approximately $8.5 billion of debt. These debt refinancings have had the positive effect of lowering the Company's cost of borrowing, staggering debt maturities and, with respect to the redemption of certain convertible securities, eliminating the potential dilution from the conversion of such securities into 62.5 million shares of Time Warner common stock. In connection with these refinancings, Time Warner recognized an extraordinary loss on the retirement of debt of $55 million in 1997 and $35 million in 1996. F-45 TIME WARNER INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS —(Continued) . In addition to these refinancings, Time Warner continued its debt reduction efforts in 1998. Debt reduction of approximately $3 billion was partially ofiset by a$2.1 billion increase in debt in order to fund the 1998 redemption of Time Warner's Series M Prefened Stock (Note 11). This debt reduction was achieved principally by using cash provided by operations, proceeds from certain asset sales, cash distributions from 1"WE an8 the noncash transfer of approximately $1 billion of debt to TWE-A/N as part of the TWE-A/N Transfers (Note 2). Zero-Coupon Convertible Notes During 1998, approximately $1.15 billion accreted amount of zero-coupon convertible notes due 2013 (the "Zero-Coupon Convertible Notes") were converted into an aggregate 37.4 million shares of Time Warner common stock. To partially ofiset the dilution resulting from this conversion, Time Warner incurred a corresponding $1.15 billion of debt and used the proceeds therefrom to repurchase common stock (Note 12). Variable-Rate Notes At December 31, 1998, variable-rate senior notes consisted of $600 million principal amount of Floating Rate Reset Notes due July 29, 2009 that are redeemable at the election of the holders, in whole but not in part, on July 29, 1999 (the "Two-Year Floating Rate Notes") and $600 million principal amount of Floating Rate Reset .Notes due December 30, 2031 that are similarly redeemable at the election of the holders on December 30, 2001 (the "Five-Year Floating Rate Notes"). The Two-Year Floating Rate Notes bear interest at a floating rate equal to LIBOR less 115 basis points until July 29, 1999, at which time, if not redeemed, the interest rate will be reset at a fixed rate equal to 6.16% plus a mazgin based upon the credit risk of TW Companies at such time. The Five-Year Floating Rate Notes bear interest at a floating rate equal to LIBOR less 25 basis points until December 30, 2001, at which time, if not redeemed, the interest rate will be reset at a fixed rate equal to 6.59% plus a margin based upon the credit risk of TW Companies at such time. Bank Credit Agreement As part of the debt refinancings referred to above, Time Wamer, together with certain of its consolidated and unconsolidated subsidiaries, entered into a five-yeaz revolving credit facility in November .1997 (the "1997 Credit Agreement") and terminated its subsidiaries' financing arrangements under certain previously existing bank credit facilities (the "Old Credit Agreements"). This enabled Time Wamer to reduce its aggregate borrowing availability from $10.3 billion to $7.5 billion, lower interest rates and refinance outstanding borrowings under the Old Credit Agreements in the amounts of approximately $2.4 billion by subsidiaries of Time Warner and $2.1 billion by TWE. The 1997 Credit Agreement permits borrowings in an aggregate amount of up to $7.5 billion, with no scheduled reduction in credit availability prior to maturity in November 2002. The borrowers under the 1997 Credit Agreement are Time Warner, TW Companies, TBS, TWI Cable, TWE and TWE-A/N. Borrowings under the 1997 Credit Agreement aze limited to (i) $6 billion in the aggregate for Time Warner, TW Companies, TBS and TWI Cable, (u) $7.5 billion in the case of TWE and (iii) $2 billion in the case of TWE-A/N, subject in each case to an aggregate borrowing limit of $7.5 billion and certain otber limitations and adjustments. Such borrowings bear interest at specific rates for each of the borrowers (generally equal to LIBOR plus a margin initially ranging from 35 to 40 basis points) and each borrower is required to pay a commitment fee on the unused portion of its commitment (initiallv ranging from .125% to .15% per annum), which margin and fee vary based on the credit rating or financial leverage of the applicable borrower. Borrowings may be used for general business purposes and unused credit is available to support commercial paper borrowings. The 1997 Credit Agreement contains certain covenants generally for each borrower relating to, among other things, additional indebtedness; liens on assets; cash flow coverage and leverage ratios; and dividends, distributions and other restricted cash payments or transfers of assets from the borrowers to their respective shareholders, partners or affiliates. F-46 TIME WARNER INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS —(Continued) Credit Agreement with TWE Time Warner has a credit agreement with TWE that allows it to borrow up to $400 million from TWE through September 15, 2000. Outstanding borrowings from TWE in the amount of $400 million bear interest at LIBOR plus 1% per annum. All amounts due to TWE under this agreement have been reclassified to Time Warner's investment in and amounts due to and from the Entertainment Group in the accompanying consolidated balance sheet. Interest Expense and Maturities At December 31, 1998, Time Warner had interest rate swap contracts to pay floating-rates of interest and receive fixed-rates of interest on $1.6 billion notional amount of indebtedness, which resulted in approximately 37% of Time Warner's underlying debt being subject to variable interest rates (Note 15). Interest expense amounted to $891 million in 1998, $1.049 billion in 1997 and $968 million in 1996, including $6 million in 1998, $19 million in 1997 and $26 million in 1996 which was paid to TWE in connection with borrowings under Time Warner's $400 million credit agreement with T'WE. The weighted- average interest rate on 1"ime Warner's total debt, including the effect of interest rate swap contracts, was 72% at December 31, 1998 and 1997. Annual repayments of long-term debt for the five years subsequent to December 31, 1998 consist of $500 million due in 2000, and $1.234 billion due in 2002. Such repayments exclude the aggregate redemption prices of $600 million in 1999 and $600 million in 2001 relating to the variable-rate senior notes, in the years in which the holders thereof may first exercise their redemption options. Fair Value of Debt Based on the level of interest rates prevailing at December 31, 1998 and 1997, the fair value of Time Warner's fixed-rate debt exceeded its carrying value by $1.098 billion and $753 million, respectively. Unrealized gains or losses on debt do not result in the realizarion or expenditure of cash and generally are not recognized for financial reporting purpcues unless the debt is retired prior to its maturity. 8. BORROWINGS AGAINST FUTURE 5TOCK OPTION PROCEEDS In 1998, in connection with Time Warner's expanded common stock repurchase program (Note 12), Time Warner entered into a new five-year, $1.3 billion revolving credit facility (the "Stock Option Proceeds Credit Facility"), which replaced its previously existing facility. Borrowings under the Stock Option Proceeds Credit Facility are principally used to fund stock repurchases and approximately $12 million of future preferred dividend requirements on Time Warner's convertible preferred stock as of December 31, 1998. At December 31, 1998 and 1997, Time Warner had outstanding borrowings against future stock option proceeds of $895 million and $533 million, respectively. The Stock Option Proceeds Credit Facility initially provides for borrowings�of up to $1.3 billion, of which up to $125 million is reserved solely for the payment of interest and fees thereunder. Borrowings under the Stock Option Proceeds Credit Facility generally bear interest at LIBOR plus a margin equal to 75 basis points and are principally expected to be repaid fmm the cash proceeds received from the exercise of designated employee stock options. The receipt of such stock option proceeds in excess of $900 million through March 2000, and thereafter in full on a cumulative basis, permanently reduces the borrowing availability under the facility. At December 31, 1998, based on a closing market price of Time Warner common stock of $62.06, the aggregate value of potential proceeds to Time Warner from the exercise of outstanding vested, "in the money" stock options covered under the facility was approximately $1.9 billion, representing a 1.5 to 1 coverage ratio over the related $1.3 billion borrowing availability. To the extent that such stock option proceeds are not sufficient to satisfy Time Warner's obligations under the Stock Oprion Proceeds Credit F-47 TIME WARNER INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS —(Continued) Facility, Time Warner is generally required to repay such borrowings using proceeds from the sale of shares of its common stock held in escrow under the Stock Option Proceeds Credit Facility or, at Time Warner's election, using available cash on hand. Time Warner had placed 76 million shares in escrow at December 31, 1998, which shares are not considered to be issued and outstanding capital stock of the Company. Time Warner may be required, from time to time, to have up to 210 million shares held in escrow. In addition, as a result of Time Warner's commitment to use the Stock Option Proceeds Credit Facility to fund future preferred dividend requirements on certain classes of its convertible preferred stock, Time Warner has also supplementally agreed to place in escrow an amount of cash equal to any excess of the unpaid, future preferred dividend requirements on such series of convertible preferred stock over the borrowing availability under the facility at any time. 9. INCOME TAXES Domestic and foreign pretax income {loss) are as follows: Domestic................................................. Foreign....................... ......................... Total.................................................... Years Ended December 31, 1998 1997 1996 (millions) $486 $728 $(193) 100 104 197 $586 $832 $ 4 Current and deferred income taxes (tax benefits) provided are as follows: Federal: Current�� ............................................. Deferred.............................................. Foreign: Current�2� .......................................:..... Deferred.............................................. State and Local: , . Current�'� ............................................. Deferred.............................................. Total................................................... Years Ended December 31, 1998 1997 1996 (millions) $ 436 $191 $ 50 (259) 49 (143) 260 205 (49) (3) 166 88 �136) 1 $ 418 $531 230 (16) 89 (50) $ 160 (i) Includes utiliution oF tax carryforwards of $126 miltion in 1998, $109 million in 1997 and $77 million in 1996. Excludes current federal and state and local tax benefiu of $478 miliion in 1998, $165 miilion.in 199? and $20 million in 1996 resulting from the exercise of stock options and vesting of restricted stock awards, which were credited directly to paid-in-capital. Excludes current federal tax benefits of $30 million in 1997 and $4 million in 1996 resulting from the retirement oP debt, which reduced the extraordinary losses in such years. (2) ]ncludes foreign withholding taxes of $113 million in 1998, $114 million in 1997 and $101 million in 1996. The differences between income taxes expected at the U.S. federal statutory income tax rate of 35% and income taxes provided are as set forth below. The relationship between income before income taxes and income tax expense is most affected by the amortization of goodwill and certain other financial statement expenses that are not deductible for income tax purposes. F-48 TIME WARNER INC. NOTES TO CONSOLIDATED FINANCL�iL. STATEMENTS —(Continued) Taxes on income at U.S. federal statutory rate . . . . . . . . . . . . . . . . . . . . . State and local taxes, net of federal tax benefits . . . . . . . . . . . . . . . . . . . . Nondeductible goodwill amortization . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Othernondeductible expenses ................................... Foreign income taxed at different rates, net of U.S. foreign tax credits .... Other........................................................ Total........................................................ Years Eaded December 31, 1998 1997 1996 (millions) $205 $291 $ 2 20 58 � 26 170 170 131 13 11 10 — 9 4 10 �) �13) $418 $531 $160 Significant components of Time Wamer's net deferred tax liabilities are as follows: Assets acquired in business combinations . . . . . . . . . . . . . . . . . . . . . . . . . . . . Depreciation and amortization . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Unrealized appreciation of certain marketable securities . . . . . . . . . . . . . . . . . . Other............................................................. Deferred tax liabilities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Tax carryforwards .................................................. Accrued liabilities ...... ......................................... Receivable allowances and return reserves . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Other............................................................. Deferred tax assets .........:........................................ Net deferred tax liabilities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . December 31, 1998 1997 (millions) $3,158 $3,352 1,112 1,152 4 4 452 449 4,726 4,957 304 327 513 381 217 203 201 86 1,235 997 $3,491 $3,960 U.S. income and foreign withholding taxes have not been recorded on permanently reinvested earnings of foreign subsidiaries aggregating approximately $945 million at December 31, 1998. Determination of the amount of unrecognized deferred U.S. income tax liability with respect to such earnings is not practicable. If such earnings are repatriated, additional U.S. income and foreign withholding taxes are substantially expected to be offset by the accompanying foreign tax credits. U.S. federal tax carryforwatds at December 31, 1998 consisted of $456 aullion of net operating losses, $109 million of investment tax credits and $34 million of altemative minimum tax credits. The utilization of certain carryforwards is subject to limitations under U.S. federal income tax laws. Except for the alternative F-49 TIME WARNER INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS —(Continued) minimum tax credits which do not expire, the other U.S. federal tax carryforwards expire in varying amounts as follows for income tax reporting purposes: 1999 ........................................................... 2000 ........................................................... 2001 ........................................................... 2002 ........................................................... Thereafter up to 2011 ............................................ 10. MANDATORILY REDEEMABLE PREFERRED SECURITIES Carryforwards Net Investment Operating Taz Losses Credits (millions) $ 3 $ 1 1 12 2 35 — 32 450 29 $456 $109 In August 1995, Time Warner issued approximately 12.1 million Company-obligated mandatorily redeemable preferred securiries of a wholly owned subsidiary ("PERCS") for aggregate gross proceeds of $374 million. The PERCS were mandatorily redeemable in December 1997 for an amount per PERCS equal to the lesser of $54.41, and the market value of 1.5 shares of common stock of Hasbro, Inc. ("Hasbro") on December 17, 1997, payable in cash or, at Time Wamer's option, Hasbro common stock. Pursuant to these terms, Time Warner redeemed the PERCS in December 1997 for all of its 18.1 million shares of Hasbro common stock. In connection with this redemption and the related disposal of its interest in Hasbro, Time Warner recognized a$200 million pretax gain in 1997, which has been classified in interest and other, net, in the accompanying consolidated statement of operations. In December 1995, Time Warner issued approximately 23 million Company-obligated mandatorily redeemable preferred securiries of a wholly owned subsidiary ("Prefened Trust Securities") for aggregate gross proceeds of $575 million. The sole assets of the subsidiary that is the obligor on the Preferred Trust Securities are $592 million principal amount of 8�/a% subordinated debentures of TW Companies due December 31, 2025. Cumulative cash distributions are payable on the Preferred Trust Securities at an annual rate of 8'/s%. The Preferred Trust Securities aze mandatorily redeemable for cash on December 31, 2025, and Time Warner has the right to redeem the Preferred Trust Securities, in whole or in part, on or after December 31, 2000, or in other certain circumstances, in each case at an amount per Preferred Trust Security equal to $25 plus accrued and unpaid distributions thereon. Time Warner has certain obligations relating to the Preferred Trust Securities which amount to a full and unconditional guaranty (on a subordinated basis) of its subsidiary's obligations with respect thereto. 11. REDEMPTION OF SERIES M PREFERRED STOCK In December 1998, Time Warner redeemed all of its outstanding shares of 101/a% Series M Preferred Stock, which were issued initially in April 1996. The aggregate redemption cost of approximately $2.1 billion was funded with proceeds from the issuance of lower-cost debt. As a result of this redemption, preferred dividend requirements in Time Warner's 1998 consolidated statement of operations include a one-time effect of $234 million ($.19 loss per common share) relating to the redemption premium paid in connection therewith. Because the weighted-average interest rate of the debt is approximately 375 basis points lower than the dividend rate of the Series M Preferred Stock and the interest on the debt is tax deductible (whereas F-50 TIME WARNER INC. NOTES TO CONSOLIDATED FINANCIAL STAT'EMENTS —(Continued) dividends are not), Time Warner expects to realize approximately $100 to $125 million of annual cash savings as a result of this redemption. 12. SHAREHOLDERS' EQUITY At December 31, 1998, shareholders' equity of Time Warner included 22.6 million shares of convertible preferred stock that are convertible into 94.1 million shares of common stock, 57.1 million shares of Series LMCN-V Common Stock that are convertible into 1142 million shares of common stock and 1.118 billion shares of common stock (net of 18.7 million shares of common stock in treasury). Time Warner currently is authorized to issue up to 250 million shares of preferred stock, up to 2 billion shares of common stock and up to 200 million shares of additional classes of common stock, including Series LMCN-V Common Stock. In December 1998, a two-for-one common stock split was effectuated by the payment of a 100°lo stock dividend in the amount of 558.2 million shares of common stock (the "1998 Stock Split"). The 1998 Stock Split did not af�'ect the number of shares of Series LMCN-V Common Stock outstanding. Accordingly, each share of Series LMCN-V Common Stock now is equivalent effectively to two shares of common stock. Shares of Series LMCN-V Common Stock continue to have limited voting rights. During 1998 and January 1999, Time Warner issued approximately 66 million shares of common stock in connection with the conversion of 15.8 million shares of convertible preferred stock. These conversions are expected to result in approximately $60 million of cash dividend savings in the aggregate for Time Warner through the end of 1999. During 1998, Time Wamer acquired 59.9 million shares of its common stock at an aggregate cost of $2.24 billion under its existing common stock repurchase program, thereby increasing the cumulative shares purchased to approximately 95.1 million shares at an aggregate cost of $3.04 billion. Except for repurchases of common stock using borrowings in 1998 that offset $1.15 billion of debt reduction associated with the conversion of the ZeraCoupon Convertible Notes into common stock, these repurchases were funded with stock option exercise proceeds and borrowings under Time Warner's Stock Option Proceeds Credit Facility. In January 1999, Time Warner's Board of Directors authorized a new common stock repurchase program that allows the Company to repurchase, from time to time, up to $5 billion of common stock. This program is expected to be completed over a three-yeaz period. However, actual repurchases in any period will be subject to market condirions. Along with stock option exercise proceeds and bonowings under the Stock Option Proceeds Credit Facility, additional funding for this program is expected to be provided by anticipated future free cash flow and financial capacity. As of December 31, 1998, Time Wamer had approximately 22.6 million shares of convertible preferred stock outstanding. However, in January 1999, all of the outstanding shazes of Series G and Series H preferred F-51 TIME WARNER INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS —(Continued) stock were converted into 12.5 million shares of common stock. Set forth below is a summary of the principal terms of Time Warner's classes of convertible preferred stock: Number of Shares Final $3.75 of Common Stock Per Share Earliest Earliest Shares Issuable Upon Dividend Exchange Redemption Description Outstanding Conversion Date Date Date (millions) (millions) Series D preferred stock . . . . . . . . . . . . . Series E preferred stock . . . . . . . . . . . . . Series F preferred stock . . . . . . . . . . . . . Series G preferred stock . . . . . . . . . . . . . Series H preferred stock . . . . . . . . . . . . . Series I preferred stock . . . . . . . . . . . . . Series J preferred stock . . . . . . . . . . . . . Total shares outstanding at December 31, 1998 . . . . . . . . . . . . . . . Conversion of Series G and H preferred stock in January 1999. .... Total shares outstanding at January 31, 1999 ........................... 11.0 3.1 3.0 1.2 1.8 0.7 1.8 45.8 13.0 12.4 5.0 7.5 2.9 7.5 22.6 94.1 �) 12.5) 19.6 81.6 7/6/99 7/6/99 7/6/00 1/4/O1 1/4/Ol 1/4/O1 1/4/00 1/4/00 1/4/O1 9/5/99 9/5/99 9/5/99 9/5/99 9/5/00 9/5/99 10/2/99 10/2/99 10/2/99 5/2/00 5/2/00 5/2/00 The principal terms of each outstanding series of convertible preferred stock (collectively, the "Converti- ble Preferred Stock") are similar in nature, unless otherwise noted below. Each share of Convertible Preferred Stock: (1) is entitled to a liquidation preference of $100 per share, ( 2) is immediately convertible into 4.16528 shares of Time Warner common stock at a conversion price of $24 per share (based on its liquidation value), (3) entitles the holder thereof (i) to receive for a four-year period from the date of issuance (or a five-year period with respect to the Series E and Series J preferred stock) an annual dividend per share equal to the greater of $3.75 and an amount equal to the dividends paid on the Time Warner common stock into which each share may be converted and (ii) to the extent that any of such shares of preferred stock remain outstanding at the end of the period in which the minimum $3.75 per share dividend is to be paid, the holders thereafter will receive dividends equal to the dividends paid on shares of Time Warner common stock multiplied by the number of shares into which their shares of preferred stock are convertible and (4) entitles the holder thereof to vote with the common stockholders on all matters on which the common stockholders are entitled to vote, and each share of such Convertible Preferred Stock is entitled to four votes on any such matter. Time Warner has the right to exchange each series of Convertible Preferred Stock for Time Warner common stock at the stated conversion price at any time on or after the respective exchange date. In addition, Time Warner has the right to redeem each series of Convertible Preferred Stock, in whole or in part, for cash at the liquidation value plus accrued dividends, at any time on or after the respective redemption date. Pursuant to Time Warner's shareholder rights plan, as amended, each share of Time Warner common stock has attached to it one right, which becomes exercisable in certain events involving the acquisition of 15% or more of the then outstanding common stock of Time Warner on a fully diluted basis. Upon the occurrence of such an event, each right entitles its holder to purchase for $75 the economic equivalent of common stock of Time Warner, or in certain circumstances, of the acquiror, worth twice as much. In connection with the plan, 8 million shares of prefened stock were reserved. The rights expire on January 20, 2004. At December 31, 1998, Time Warner had convertible securities and outstanding stock options that were. convertible or exercisable into approximately 230 million shares of common stock (as adjusted for the January 1999 conversion of Series G and Series H preferred stock). F-52 TIME WARNER IlVC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS —(Continued) At February 28, 1999, there were approximately 25,000 holders of record of Time Warner common stock. T'his total does not include the large number of investors who hold such shares through banks, brokers or other fiduciaries. 13. STOCK OPTION PLANS Time Warner has various stock option plans under which Time Warner may grant options to purchase Time Warner common stock to employees of Time Warner and TWE. Such options have been granted to employees of Time Warner and TWE with exercise prices equal to, or in excess of, fair mazket value at the date of grant. Accordingly, in accordance with APB 25 and related interpretations, compensation cost is not generally recognized for its stock option plans. Generally, the options become exercisable over a three-year vesting period and expire ten years from the date of grant. Had compensation cost for Time Warner's stock option plans been detertnined based on the fair value at the grant dates for all awards made subsequent to 1994 consistent with the method set forth under FASB Statement No. 123, "Accounting for Stock-Based Compensation" ("FAS 123"), Time Warner's net income (loss) and net loss per common share would have been changed to the pro forma amounts indicated below: Years Ended December 31, 1998 1997 1996 (millions, except per share amounts) Net income (loss): As reported ............ ................................. $ 168 $ 246 $ 191) Pro forma ................................................ $ 106 $ 200 $(216) Net loss per common shaze: As reported ............................................... $i.31) $�) $ (.52) Pro forma ................................................ $�) $�0) $ .55) FAS 123 is applicable only to stock options granted subsequent to December 31, 1994. Accordingly, since Time Warner's compensation expense associated with such grants would generally be recognized over a three- year vesting period, the initial impact of applying FAS 123 on pro forma net income for 1996 is not comparable to the impact on pro forma net income for 1998 and 1997, when the pro forma effect of the three- year vesting period has been fully reflected. � For purposes of applying FAS 123, the fair value of each option grant is estimated on the date of grant using the Black-Scholes option-pricing model with the following weighted-average assumptions used for grants in 1998, 1997 and 1996: dividend yields of O.S�o, l�n and 196, respectively; expected volatility of 21.6%, 21.9% and 21.7%, respectively; risk-free interest rates of 5.59'0, 6.49b and 6.1�'0, respectively, aad expected lives of 5 years in all periods. The weighted average fair value of an option granted during the year was $11.13 ($6.57, net of taxes), $6.58 ($3.88, net of taxes) and $5.78 ($3.41, net of taxes) for the years ended December 31, 1998, 1997 and 1996, respectively. In each period, Time Warner granted options to certain executives at exercise prices exceeding the market price of Time Warner common stock on the date of grant. These above-market options had a weighted average exercise price and fair value of $49.54 and $9.45 ($5.58, net of taxes), respectively, in 1998; $32.45 and $6.29 ($3.71, net of taxes), respectively, in 1997; and $26.44 and $4.44 ($2.62, net of taxes), respectively, in 1996. F-53 TIME WARNER INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -(Continued) A summary of stock option activity under all plans is as follows: Balance at January 1,1996 ....................................... Granted....................................................... Exercised...................................................... Assumed in connection with the TBS Transaction . . . . . . . . . . . . . . . . . . . . Cancelled............................................. ....... Balance at December 31, 1996 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Granted.......... ........................................... Exercised...................................................... Cancelled...................................................... Balance at December 31, 1997 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Granted....................................................... Exercised...................................................... Cancelled................................................... . Balance at December 31, 1998 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1998 Exercisable ............................................ 112,471 Available for future grants . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 11,207 Thousands of Shares 157,238 18,920 (7,372) 27,425 (477) 195,734 16,544 (32,632) (942) 178,704 18,100 (48,323) (417) 148,064 December 31 1997 (thousands) 145,616 12,771 Weighted- Average Exercise Price $15.68 21.65 13.45 13.20 20.41 $15.98 22.41 13.66 18.89 $16.99 37.71 15.01 28.01 $20.14 1996 165,394 16,063 The following table summarizes information about stock options outstanding at December 31, 1998: Range of Exercise Prices Under$10 ................. $10.00 to $15.00 . . . . . . . . . . . $15.01 to $20.00 . . . . . . . . . . . $20.01 to $30.00 . . . . . . . . . . . $30.01 to $45.00 . . . . . . . . . . . $45.01 to $54.05 . . . . . . . . . . . Total ..................... Options Outstanding Weighted- Average Weighted- Number Remaining Average Outstsnding Contrsctual Exercise at 12/31/98 Life Price (thousands) 7,726 25,239 59,851 35,538 16,573 3,137 148,064 1.7 years 3.1 years 4.3 years 6.4 years 8.9 years 9.1 years 5.1 years $ 8.98 $12.14 $18.20 $22.02 $35.09 $48.44 $20.14 Options Exercisable Weighted- Number Arerage Exercisable Exercise at ]2/31/98 Price (thousands) 7,726 $ 8.98 25,239 $12.14 55,545 $18.16 23,056 $21.73 905 $31.75 112,471 $17.02 For opdons exercised by employees of TWE, Time Warner is reimbursed by TWE for the amount by which the mazket value of Time Warner common stock on the exercise date exceeds the exercise price, or the greater of the exercise price or $13.88 for options granted prior to the TWE capitalization on June 30, 1992. There were 47.7 million options held by employees of TWE at December 31, 1998, 33.4 million of which were exercisable. F-54 TIME WARNER INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS —(Continued) 14. BENEFIT PLANS Time Warner and its subsidiaries have defined benefit pension plans covering substantially all domestic employees. Pension benefits are based on formulas that reflect the employees' years of service and compensation levels during their employment period. Time Wamer's common stock represents approximately 12% and 7% of plan assets at December 31, 1998 and 1997, respectively. A summary of activity for Time Warner's defined benefit pension plans is as follows: Years Ended December 31, 1998 1997 1996 (millions) Components of Pension Expense Servicecost ................................................... $ 53 $ 45 $ 49 Interest cost .................................................. 74 68 64 Expected return on plan assets ................................... (73) (62) (57) Net amortization and deferral . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2 1 4 Total........................................................ $ 56 $ 52 $ 60 Change in Projected Benefit Obligation Projected benefit obligation at beginning of year . . . . . . . . . . . . . . . . . . . . . . . Servicecost ...................................................... Interestcost...................................................... Actuarialloss ..................................................... Benefitspaid ..................................................... Projected benefit obligation at end of year ............................. Change in Plan Assets Fair value of plan assets at beginning of year . . . . . . . . . . . . . . . . . . . . . . . . . . Actualreturn on plan assets ........................................ Employer contribution ............................................. Benefitspaid ..................................................... Fair value of plan assets at end of year . . . . . . . . . . . . . . . . . . . . . . . . . . . : . . . Unfunded projected benefit obligation ................................ Additional minimum liability�� . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Unrecognized actuarialloss (gain) ................................... Unrecognized prior service cost ...................................... Accrued pension expense ........................................... December 31, 1998 1997 (millions) $ 990 53 74 98 (52) 1,163 839 191 16 ��) 1,000 (163) (33) (16) 16 $ (196) $ 850 45 68 78 (51) 990 704 162 15 (42) 839 (151) (38) 3 15 $(171) (a) The additional minimum liability is offset fully by a corresponding intangible asset recognized in the consolidated balance sheet. F-55 TIME WARNER INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS —(Continued) Weighted-Average Pension Assumptions Discountrate ................................................... Expected return on plan assets Rate of compensation increase .................................... .................................... December 31, 1998 1997 1996 6.75% 7.25% 7.75% 9% 9% 9% 6% 6% 6% Included above are projected benefit obligations and accumulated benefit obligations for unfunded defined benefit pension plans of $118 million and $97 million as of December 31, 1998, respectively; and $94 million and $72 million as of December 31, 1997, respectively. Employees of Time Warner's operations in foreign countries participate to varying degrees in local pension plans, which in the aggregate are not significant. Time Warner also has certain defined contribution plans, including savings and profit sharing plans, as to which the expense amounted to $84 million in 1998, $83 million in 1997 and $67 million in 1996. Contributions to the savings plans are based upon a percentage of the employees' elected contributions. Contributions to the profit sharing plans are generally determined by management and approved by the boards of directors of the participating companies. 15. DERIVATIVE FINANCIAL INSTRUMENTS Time Warner uses derivative financial instruments principally to manage the risk that changes in interest rates will affect either the fair value of its debt obligations or the amount of its future interest payments and, with regard to foreign currency exchange rates, to manage the risk that changes in exchange rates will affect the amount of unremitted or future royalties and license fees to be received from the sale of U.S. copyrighted products abroad. The following is a summary of Time Warner's risk management strategies and the effect of these strategies on Time Warner's consolidated financial statements. Interest Rate Risk Management Interest Rate Swap Contracts Interest rate swap contracts are used to adjust the proportion of total debt that is subject to variable and fixed interest rates. Under an interest rate swap contract, Time Warner either agrees to pay an amount equal to a specified variable-rate of interest times a notional principal amount, and to receive in return an amount equal to a specified fixed-rate of interest times the same notional principal amount or, vice versa, to receive a variable-rate amount and to pay a fixed-rate amount. The notional amounts of the contract are not exchanged. No other cash payments are made unless the contract is terminated prior to maturity, in which case the amount paid or received in settlement is established by agreement at the time of termination, and usually represents the net present value, at current rates of interest, of the remaining obligations to exchange payments under the terms of the contract. Interest rate swap contracts are entered into with a number of major financial institutions in order to minimize counterparty credit risk. Time Wamer accounts for its interest rate swap contracts differently based on whether it has agreed to pay an amount based on a variable-rate or fixed-rate of interest. For interest rate swap contracts under which Time Warner agrees to pay variable-rates of interest, these contracts are considered to be a hedge against changes in the fair value of Time Warner's fixed-rate debt obligations. Accordingly, the interest rate swap contracts are reflected at fair value in Time Wamer's consolidated balance sheet and the related portion of fixed-rate debt being hedged is reflected at an amount equal to the sum of its carrying value plus an adjustment representing the change in fair value of the debt obligations attributable to the interest rate risk being hedged. In addition, changes during any accounting period in the fair value of these interest rate swap contracts, as well as offsetting changes in the adjusted carrying value of the related portion of fixed-rate debt F-56 TIME WARNER INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS —(Continued) being hedged, are recognized as adjustments to interest expense in Time Warner's consolidated statement of operations. The net effect of this accounting on Time Warner's operating results is that interest expense on the portion of fixed-rate debt being hedged is generally recorded based on variable interest rates. For interest rate swap contracts under which Time Warner agrees to pay fixed-rates of interest, these contracts are considered to be a hedge against changes in the amount of future cash flows associated with Time Warner's interest payments of Time Warner's variable-rate debt obligations. Accordingly, the interest rate swap contracts are reflected at fair value in Time Warner's consolidated balance sheet and the related gains or losses on these contracts are deferred �in shareholders' equity (as a component of comprehensive income). These deferred gains and losses are then amortized as an adjustment to interest expense over the same period in which the related interest payments being hedged are recognized in income. However, to the extent that any of these contracts aze not considered to be perfectly effecrive in offsetting the change in the value of the interest payments being hedged, any changes in fair value relating to the ineffective portion of these contracts are immediately recognized in income. The net effect of this accounting on Time Warner's operating results is that interest expense on the portion of variable-rate debt being hedged is generally recorded based on fixed interest rates. At December 31, 1998, Time Warner had interest rate swap contracts to pay variable-rates of interest (average six-month LIBOR rate of 5.5%) and receive fixed-rates of interest (averagc rate of 5.5%) on $1.6 billion notional amount of indebtedness, which resulted in approximately 37% of Time Warner's underlying debt, and 39% of the debt of Time Warner and the Entertainment Group combined, being sub�ect to variable interest rates. The norional amount of outstanding contracts by year of maturity at December 31; 1998 is as follows: 1999-$1.2 billion; and 2000-$400 million. At December 31, 1997, Time Warner had interest rate swap contracts on $2.3 billion notional amount of indebtedness. The net gain or loss on the ineffective portion of these interest rate swap contracts was not material in any period. Interest Rate Lock Agreements In the past, Time Wamer somerimes has used interest rate lock agreements to hedge the risk that the cost of a future issuance of fixed-rate debt may be adversely af%cted by changes in interest rates. Under an interest rate lock agreement, Time Warner agrees to pay or receive an amount equal to the difference between the net present value of the cash flows for a notional principal amount of indebtedness based on the existing yield of a U.S. treasury bond at the date when the agreement is established and at the date when the agreement is settled, typically when Time Warner issues new debt. The notional amounts of the agreement are not exchanged. Interest rate lock agreements are entered into with a number of major financial institutions in order to minimize counterparty credit risk Interest rate lock agreements are reflected at fair value in Time Warner's consolidated balance sheet and the related gains or losses on these agreements are deferred in shareholders' equity (as a component of comprehensive income). These deferred gains and losses are then amortized as an adjustment to interest expense over the same period in which the related interest costs on the new debt issuances are recognized in income. At December 31, 1998, Time Warner had outstanding interest rate lock agreements for an aggregate $650 million notional principal amount of indebtedness, which were settled in January 1999. Time Warner no longer intends to use interest rate lock agreements to hedge the cost of future issuances of fixed-rate debt. At December 31, 1998, Time Warner had deferred approximately $32 million of net losses on interest rate lock agreements, of which approximately $2 million is expected to be recognized in income over the next twelve months. F-57 TIME WARNER INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS —(Continued) Foreign Currency Risk Management Foreign exchange contracts are used primarily by Time Warner to hedge the risk that unremitted or future royalties and license fees owed to Time Warner or TWE domestic companies for the sale or anticipated sale of U.S. copyrighted products abroad may be adversely affected by changes in foreign currency exchange rates. As part of its overall strategy to manage the level of exposure to the risk of foreign currency exchange rate fluctuations, Time Warner hedges a portion of its and TWE's combined foreign currency exposures anticipated over the ensuing twelve-month period. At December 31, 1998, Time Warner had effectively hedged approximately half of the combined estimated foreign currency exposures that principally relate to anticipated cash flows to be remitted to the U.S. over the ensuing twelve-month period. To hedge this exposure, Time Warner used foreign exchange contracts that generally have maturities of three months or less, which generally will be rolled over to provide continuing coverage throughout the year. Time Warner often closes foreign exchange sale contracts by purchasing an offsetting purchase contract. Time Warner reimburses or is reimbursed by TWE for contract gains and losses related to TWE's foreign cunency exposure. Foreign exchange contracts are placed with a number of major financial institutions in order to minimize credit risk. Time Warner records these foreign exchange contracts at fair value in its consolidated balance sheet and the related gains or losses on these contracts are deferred in shareholders' equity (as a component of comprehensive income). These deferred guns and losses are recognized in income in the period in which the related royalties and license fees being hedged are received and recognized in income. However, to the extent that any of these contracts are not considered to be perfecdy effective in offsetting the change in the value of the royalties and license fees being hedged, any changes in fair value relating to the ineffective portion of these contracts are immediately recognized in income. Gains and losses on foreign exchange contracts are generally included as a component of interest and other, net, in Time Warner's consolidated statement of operations. At December 31, 1998, Time Warner had contracts for the sale of $755 million and the purchase of $259 million of foreign currencies at fixed rates, primarily Japanese yen (40% of net contract vaiue), English pounds (4%), German marks (28%), Canadian dollars (10%) and French francs (16%), compared to contracts for the sale of $507 million and the purchase of $139 million of foreign currencies at December 31, 1997. 'Time Wamer had deferred approximately $6 million of net losses on foreign exchange contracts at December 31, 1998, which is all expected to be recognized in income over the next twelve months. For the yeazs ended December 31, 1998, 1997 and 1996, Time Warner recognized $8 million in losses, $27 million in gains and $15 million in gains, respectively, and TWE recognized $2 million in losses, $14 million in gains and $6 million in gains, respectively, on foreign exchange contracts, which were or are expected to be offset by corresponding decreases and increases, respectively, in the dollar value of foreign currency royalties and license fee payments that have been or are anticipated to be received in cash from the sale of U.S. copyrighted products abroad. 16. SEGMENT INFORMATION Time Warner classifies its businesses into four fundamental areas: Cable Networks, consisting principally of interests in cable television programming; Publishing, consisting principally of interests in magazine publishing, book publishing and direct marketing; Entertainment, consisting principally of interests in recorded music and music publishing, filmed entertainment, television production and television broadcasting; and Cable, consisting principally of interests in cable television systems. A majority of Time Warner's interests in filmed entertainment, television production, television broadcasting and cable television systems, and a portion of its interests in cable television programming are held by the Entertainment Group. The Entertainment Group is not consolidated for financial reporting purposes. Information as to the operations of Time Warner and the Entertainment Group in different business segments is set forth below based on the nature of the products and services offered. Time Warner evaluates performance based on several factors, of which the primary financial measure is business segment operating F-58 TIME WARNER INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -(Continued) income before noncash amortization of intangible assets ("EBITA"). The accounting policies of the business segments are the same as those described in the summary of significant accounting policies (Note 1). Intersegment sales are accounted for at fair value as if the sales were to third parties. The operating results of Time Warner's and the Entertainment Group's cable segments reflect the TWE-A/N Transfers effective as of January 1, 1998, the Primestar Roll-up Transaction effective as of April 1, 1998, the formation of the Road Runner Joint Venture effective as of June 30, 1998 and the Time Warner Telecom Reorganization effective as of July 1, 1998. In addition, the operadng results of Time Warner reflect the cable networks and filmed entertainment-related acquisition of TBS effective as of October 10, 1996. Revenues Time Warner.• Publishing ............................................ Music. ... .. ................................... Cable Networks-TBS . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Filmed Entertainment-TBS . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Gable...... . .................................. Intersegment elimination . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Total................................................. Years Ended December 31, 1998 1997 1996 (millions) $ 4,496 $ 4,290 $ 4,117 4,025 3,691 3,949 3,325 2,900 680 1,917 1,531 455 964 997 909 (145) (115) (46) $14,582 $13,294 $10,064 Entertainment Group: Filmed Entertainment-Warner Bros . . . . . . . . . . . . . . . . . . . . . . . $ 6,061 $ 5,472 $ 5,648 Broadcasting-The WB Network . . . . . . . . . . . . . . . . . . . . . . . . . . 260 136 87 Cable Networks-HBO .. . . . . .. . . . . . . . . . . . . . . . .. . . . . . . . . . 2,052 1,923 1,763 Cable ........ . .................................. 4,378 4,243 3,851 ... .. Intersegment elimination . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 495) (446) (488) Total ................................................. $12,256 $11,328 $10,861 EBITA�� Time Warner.� Publishing............................................... Music. .... . ...................................... Cable Networks-TBS . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .. Filmed Entertainment-TBS . . . . . . . . . . . . . . . . . . . . . . . . . . . . Cable�Z� ..... . ..................................... .... .. Intersegment elimination . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Total.................................................... Entertainment Group.• Filmed Entertainment-Warner Bros . . . . . . . . . . . . . . . . . . . . . . . . . . Broadcasting-The WB Network . . . . . . . . . . . .. .. .. . . .. . . . . . . .. Cable Networks-HBO . . . . . . . . . . . . . . . . . . . . . . . . . Cable�3� ................................................. Total.................................................... Yesrs Ended December 31, 1998 1997 1996 (millions) $ 607 $ 529 $ 464 493 467 653 706 573 142 192 200 30 325 427 353 (27) (13) 5 $2,296 $2,183 $1,647 $ 503 (93) 454 1,369 $2,233 $ 404 $ 379 i88) (98) 391 328 1,184 917 $1,891 $1,526 ( I) EBITA represents business segment operating income before nonrash amortiution of intangible assets. After deducting amortiution of intangible assets, Time Wamer's business segment operating income was $1.496 billion in 1998, $1.27! billion in 1997 and $966 million in 1996. Similarly, business segment operating income of the Entertainment Group was $1.724 billion in 1998, $1.461 billion in 1997 and $1.090 billion in 1996. (2) lncludes net pretax gains of approximately $18 million in 1998 and S12 million in 1997 relatcd to the sale or exchange of certain cable television systems. (3) Includes net pretax gains of approximately $90 million in 1998 and 3200 million in 1997 related to the sale or exchange of certain cable television systems. F-59 TIME WARNER INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS —(Continued) Depreciation of Property, Plant and Equipment Time Warner.� Publishing.................................................... Music... ..................... ........:.......... Cable Networks-TBS ..................................... Filmed Entertainment-TBS . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Cable........................................................ Total........................................................ Years Ended December 31, 1998 1997 1996 (millions) $ 80 $ 79 72 83 93 87 6 7 127 126 $378 $382 Entertainment Group: Filmed Entertainment-Warner Bros . . . .. . . . . . . . . . . .. . . . . . . . . . . . . . . $166 $197 Broadcasting-The WB Network .................................. 1 1 Cable Networks-HBO .......................................... 23 22 Cable........................................................ 737 736 Total........................................................ $927 $956 Amortization of Intangible Assets�� Time Warner.• Publishing.................................................... Music...... .......................................... Cable Networks-TBS . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . : . Filmed Entertainment-TBS . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Cable........................................................ Total........................................................ Entertainment Group: Filmed Entertainment-Warner Bros . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Broadcasring-The WB Network .................................. Cable Networks-HBO : . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Cable........................................................ Total........................................................ $ 71 91 20 2 123 $307 $167 22 619 $808 Years Ended December 31, 1998 1997 19% (millions) $ 38 $ 48 $ 46 280 301 292 200 199 43 82 87 22 200 277 278 $800 $912 $681 $129 $123 $125 3 — — 377 307 311 $509 $430 $436 ( I) Amortization includes amortization relating to all business combinations accounted for by the purchase method, including the $14 billion acquisition of Wamer Communications Inc. in 1989, the $6.2 biliion acquisition of TBS in 1996 and the $2.3 billion of cable acquisitions in 1996 and 1995. F-60 TIME WARNER INC. N01'ES TO CONSOLIDqTED FINANCIAL STATEMENTS -(Continued) Information as to the assets and capital expenditures of Time Warner and the Entertainment Group is as follows: Assets Time Warner.• Publishing............................................ Music................................................ Cable Networks-TBS . . . . . . . . . . . . . . . . . . . . . . : . . . . . . . . . . . . Filmed Entertainment-TBS . . . . . . . . . . . Cable ... ......... ... ................ Entertainment Group� � � . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Corporate�Z� . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . December 31, 1998 1997 19% (millions) 2,726 7,354 8,485 2,774 4,434 4,980 887 Total................................................. $31,640 Entertainment Group.• , Filmed Entertaipment-Warner Bros . . . . . . . . . . . . . . . . . . . . . . . $ 8,811 Broadcasting-The WB Network . . . . . . . . . . . . . . . . . . . . . . 244 Cable Networks-HBO . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,159 Cable . . . . . . . . . . . . . . . . . . . . . . . . . 11,314 Corporate�2� ........................................... 713 Total................................................. $22,241 $ 2,490 6,507 8,372 2,950 7,043 5,549 1,252 $34,163 $ 8,106 113 1,080 10,771 669 $20,739 $ 2,418 7,478 7,860 3,232 7,257 5,814 1,005 $35,064 $ 8,111 67 997 10,202 650 $20,027 (1) Entertainment Group asscu represent Time Warner's investment in and amounts due to and from the Entertainment Group. (2) Consists principally of cash, cash equivalents and other investments. Capital Expenditures Time Warner.• Publishing ........................... Music. .. ......... .................... Cable Networks-TBS . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Filmed Entertainment-TBS . . . . . � � � � � � � � Cable ..................... ............................ Corporate................................................ Total.................................................... Entertainment Group.• Filmed Entertainment-Warner Bros. . . Broadcasting-The WB Network . . . . . . . . . . . . . . . . . . . . . . . . . . . . . CableNetworks-HBO... �� Cable�'� ................................................. Corporate................................................. Total.................................................... Years Ended December 31, 1998 1997 1996 (millions) $ 58 $ 77 $ 76 92 87 142 120 113 34. 3 3 2 225 282 215 14 12 12 $ 512 $ 574 $ 481 $ 122 1 23 1,451 6 $ 144 1 19 1,401 $1,603 $1,565 $ 340 2 29 1,348 $1,719 (1) Cable capital expenditures were funded in part through collections on the MediaOne Note Receiwable in the amount of $169 million in 19% (Note 4). The MediaOne Note Receiwable was fully collected during 19%. F-61 TIME WARNER INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS —(Continued) Information as to Time Warner's operations in different geographical areas is as follows: Revenues�l� Time Warner.• United States . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . United Kingdom ....................................... Germany............................................. Japan.....:.......................................... Canada............................................... France.... ... ..................................... Other international . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Total................................................. Entertainment Group: United States.. ..................................... United Kingdom ....................................... Germany............................................. Japan.:.............................................. Canada............................................... France.... . ..................................... Otherinternadonal ..................................... Years Ended December 31, 1998 1997 1996 (millions) $11,220 542 432 405 284 227 1,472 $14,582 $10,177 459 263 162 145 163 887 Total................................................. $12,256 (1) Revenues are attributed to countries based on location of customer. $10,159 449 420 417 262 195 1,392 $13,294 $ 9,096 488 284 172 137 152 999 $11,328 $ 7,262 372 452 399 209 229 1,141 $10,064 $ 8,727 383 374 196 157 143 881 $10,861 Because a substanrial portion of Time Wamer's international revenues is derived from the sale of U.S. copyrighted products abroad, assets located outside the United States are not material. 17. COMMITMENTS AND CONTINGENCIES Time Wamer's total rent expense amounted to $286 million in 1998, $237 million in 1997 and $192 million in 1996. The minimum rental commitments under noncancellable long-term operating leases are: 1999-$259 million; 2000-$244 million; 2001-$222 million; 2002-$205 million; 2003-$193 million; and after 2003-$940 million. Time Warner's minimum commitments and guarantees under certain programming, licensing, artists, athletes, franchise and other agreements aggregated approximately $6.6 billion at December 31, 1998, which are payable principally over a five-year period. Such amounts do not include the Time Warner General Partner and TWI Cable guarantees of approximately $6.7 billion of TWE's and TWE-A/N's debt and accrued interest. Time Warner is subject to numerous legal proceedings, including certain litigarion relating to Six Flags. In managemenYs opinion and considering established reserves, the resolution of these matters will not have a material effect, individually and in the aggregate, on Time Warner's financial statements. F-62 TIME WARNER INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS —(Continued) 18. RELATED PARTY TRANSACTIONS In the normal course of conducting their businesses, Time Warner and its subsidiaries and affiliates have had various transactions with TWE and other Entertainment Group companies, generally on terms resulting from a negotiation between the affected units that in managemenYs view results in reasonable allocations. Employees of TWE participate in various Time Warner medical, stock option and other benefit plans for which Time Warner chazges TWE its allocable share of plan expenses, including administrative costs. In addition, Time Warner provides 1"WE with certain corporate support services for which it received a fee in the amount of $72 million, $72 million and $69 million in 1998, 1997 and 1996, respectively. Time Warner's Cable division has managementservices agreements with TWE, pursuant to which TWE manages, or provides services to, the cable television systems owned by Time Warner. Such cable television systems also pay TWE for the right to carry cable television programming provided by TWE's cable networks. Similarly, Time Warner receives fees from TWE's cable television systems for the right to carry cable television programming provided by Time Warner's cable networks. Time Warner's and TWE's Cable division have sold or exchanged, or agreed to sell or exchange, various cable television systems to MediaOne in an effort to strengthen their geographic clustering of cable television properties. Time Warner's Filmed Entertainment-TBS division has various service agreements with TWE's Filmed Entertainment-Warner Bros. division, pursuant to which TWE's Filmed Entertainment-Warner Bros. division provides certain management and distribution services for Time Warner's theatrical, television and_ animated product, as well as certain services for administrative and technical support. Time Warner's Cable Networks-TBS division has license agreements with TWE, pursuant to which the cable networks have acquired broadcast rights to certain film and television product. In addition, Time Warner's Music division provides home videocassette distribution services to certain TWE operations, and certain TWE units place advertising in magazines published by Time Warner's Publishing division. Time Warner has a credit agreement with TWE that allows it to borrow up to $400 million from TWE through September 15, 2000. Outstanding borrowings from TWE in the amount of $400 million bear interest at LIBOR plus 1% per annum. In addition to transactions with TWE and other Entertainment Group companies, Time Wamer has had transacrions with the Columbia House Company partnerships, Comedy Partners, L.P., Time Wamer Telecom, the Road Runner Joint Venture and other equity investees of Time Warner and the Entertainment Group, generally with respect to sales of products and services in the ordinary course of business. 19. ADDITIONAL FINANCIAL INFORMATION Cash Flows As of December 31, 1998, Time Warner had certain asset securitizadon facilities, which provide for the accelerated receipt of up to approximately $1 billion of cash on available receivables. In connection with each of these securitization facilities, Time Warner sells, on a revolving and nonrecourse basis, certain of its accounts receivables ("Pooled Receivables") to a wholly owned, special purpose entity which, in turn, sells a percentage ownership interest in the Pooled Receivables to a third-party, commercial paper conduit sponsored by a financial institution. These securitization transacrions have been accounted for as a sale in accordance with FASB Statement No. 125, "Accounting for Transfers and Servicing of Financial Assets and Extinguish- ments of Liabiliries." Accordingly, accounts receivables sold under this securitization program have been reflected as a reduction in receivables in the accompanying consolidated balance sheet. Net proceeds received under this .securitizarion program were $17 million in 1998, $108 million in 1997 and $147 million in 1996. F-63 TIME WARNER INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS —(Continued) Additional financial information with respect to cash flows is as follows: Cash payments made for interest . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Cash payments made for income taxes . . . . . . . . . . . . . . . . . . . . . . . . . Tax-related distributions received from TWE . . . . . . . . . . . . . . . . . . . Income tax refunds received . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Years Ended December 31, 1998 1997 1996 (millions) $812 $929 $839 261 305 382 314 324 215 52 52 44 Noncash investing activities in 1998 included the Time Warner Telecom Reorganization, the formation of the Road Runner Joint Venture and the TWE-A/N Transfers (Note 2). Noncash financing activities included the conversion of $1.15 billion of Zero-Coupon Convertible Notes into 37.4 million shares of common stock in 1998 (Note 7) and the conversion of 12.8 million shares of convertible preferred stock into approximately 53.5 million shares of common stock (Note 12). Noncash financing activities in 1997 included the redemption of the PERCS in exchange for Time Warner's interest in Hasbro (Note 10) and the payment of $185 million of noncash dividends on the Series M Freferred Stock. Noncash investing activities in 1996 included the $6.2 billion acquisition of TBS and the $904 million acquisition of CVI in exchange for capital stock (Notes 2 and 3). Noncash financing activities in 1996 included the payment of $122 million of noncash dividends on the Series M Preferred Stock. Other Current Liabilities Other current liabilities consist of: Accrued expenses ................................................... Accrued compensation .............................................. Accrued incometaxes ............................................... Deferred revenues .................................................. December 31, 1998 1997 (miliions) $1,542 $1,716 538 430 93 28 231 205 Total ............................................................. $2,404 $2,379 F-64 REPORT OF MANAGEMENT The accompanying consolidated financial statements have been prepared by management in conformity with generally accepted accounting principles, and necessarily include some amounts that are based on management's best estimates and judgments. Time Warner maintains a system of internal accounting controls designed to provide management with reasonable assurance that assets are safeguarded against loss from unauthorized use or disposition, and that transactions aze executed in accordance with management's authorization and recorded properly. The concept of reasonable assurance is based on the recognition that the cost of a system of internal control should not exceed the benefits derived and that the evaluation of those factors requires estimates and judgments by management. Further, because of inherent limitations in any system of internal accounting control, errors or irregularities may occur and not be detected. Nevertheless, management believes that a high level of internal control is maintained by Time Warner through the selection and training of qualified personnel, the establishment and communication of accounting and business policies, and its internal audit program. The Audit Committee of the Boazd of D'uectors, composed solely of directors who are not employees of Time Warner, meets periodically with management and with Time Warner's internal auditors and indepen- dent auditors to review matters relating to the quality of financial reporting and internal accounting control, and the nature, extent and results of their audits. Time Warner's internal auditors and independent auditors have free access to the Audit Committee. Richard J. Bressler Executive Vice President and Chief Financial Off�cer F-65 John A. LaBarca Senior Yice President and Controller REPORT OF INDEPENDENT AUDITORS The Board of Directors and Shareholders Time.Warner Inc. We have audited the accompanying consolidated balance sheet of Time Warner Inc. ("Time Warner") as of December 31, 1998 and 1997, and the related consolidated statements of operations, cash flows and shareholders' equity for each of the three years in the period ended December 31, 1998. Our audits also included the financial statement schedule and supplementary information listed in the Index at Item 14(a). These financial statements, schedule and supplementary information are the responsibility of Time Warner's management. Our responsibility is to express an opinion on these financial statements, schedule and supplementary information. based on our audits. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the financial statements referred to above present fairly, in all material respects, the consolidated financial position of Time Warner at December 31, 1998 and 1997, and the consolidated results of its operations and its cash flows for each of the three years in the period ended December 31, 1998, in conformity with generally accepted accounting principles. Also, in our opinion, the related financial statement schedule and supplementary information, when considered in relation to the basic financial statements taken as a whole, present fairly in all material respects the information set forth therein. New York, New York February 3, 1999 ERNSr & Yourvc LLP F-66 TIME WARNER INC. SELECTED FINANCIAL INFORMATION The selected financial information for each of the five years in the period ended December 31, 1998 set forth below has been derived from and should be read in conjunction with the financial statements and other financial information presented elsewhere herein. Capitalized terms are as defined and described in such consolidated financial statements, or elsewhere herein. The selected historical financial information for 1998 reflects (a) the TWE-A/N Transfers and (b) the redemption of Series M Preferred Stock at an aggregate cost of approximately $2.1 billion using proceeds from the issuance of lower-cost debt. The selected historical financial information for 1996 reflects (a) the TBS Transaction, including the assumption of approximately $2.8 billion of indebtedness, (b) the use of approximately $1.55 billion of net proceeds from the issuance of Series M Prefened Stock to reduce outstanding indebtedness and (c) the acquisition of CVI, including the assumption or incurrence of approximately $2 billion of indebtedness. The selected historical financial information for 1995 reflects (a) the acquisitions of KBLCOM Incorporated and Summit Communications Group, Inc., including the assumption or incurrence of approximately $1.3 billion of indebtedness and (b) the exchange by Toshiba Corporation and ITOCHU Corporation of their direct and indirect interests in TWE. Per common share amounts and average common shazes have been restated to give effect to the two-for- one common stock split that occurred on December 15, 1998. Selected Operating Statement Information Revenues .................................. Depreciation and amortization .............. . .. Business segment operating income�a� . . . . . . . . . . Equity in �retax income of Entertainment Group�b ................................. Interest and other, net�`� . . . . . . . . . . . . . . . . . . . . . Income (loss) before extraordinary item . . . . . . . . Net income (loss) �d� . . . . . . . . . . . . . . . . . . . . . . . . Net loss applicable to common shares (after preferred dividends)�a>�`� Per share of common stock: Years Ended December 31, 1998 1997 1996 1995 1994 (millions, except per share amounts) $14,582 $13,294 $10,064 $8,067 $7,396 (1,178) (1,294) (988) (559) (437) 1,496 1,271 966 697 713 356 686 (1,180) (1,044) 168 301 168 246 (372) (73) 290 256 (1,174) (877) (156) (124) (191) (166) (448) (218) 176 (724) (91) (91) (104) Basic and diluted net loss�d��`� ............... $ (0.31) $ (0.06) $ (0.52) $(0.28) $(0.14) Dividends . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 0.18 $ 0.18 $ 0.18 $ 0.18 $0.175 Average common shares . .. ........ ........... 1,194.7 1,135.4 862.4 767.6 757.8 (a) Business segment operating income for the year cnded December 31, 1995 includes $85 million in losses relating to certain businesses and joint ventures owned by the Music division which were restructured or closed. (b) Time Wamer's equity in the pretax income of the Entertainment Group for the years ended December 31, 1998 and 1997 includes dpproximately $120 million of net losses and $450 million of gains, respectively, relating to the sale or exchange of various cable television systems and other investmcnt-related activity. (c) Interest and other, net, for the yexr ended December 31, 1997 includcs a 5200 million pretax gain relating to the disposal of Time Wxrner's interest in Hasbro and the related redemption of certain mandatorily redeemable preferred securities of a subsidiary. (d) Net income (loss) for each of the years ended December 31, 1997, 1996 and 1995 includes an extraordinary loss on the retirement of debt of $55 million ($.OS per common share), $35 million ($.04 per common sharc) and $42 million ($.OS per common share), respectively. (e) Preferred dividend requirements for the year ended December 31, 1998 include a one-time efi'ect of $234 million ($.19 loss per common share) relating to the premium paid in connection with the redemption of Time Warner's Series M Preferred Stock. F-67 1998 ` 1997 Setected Balance Sheet Information Cash and equivalents ...................... $ 442 $ 645 Total assets . . . .. . . . ... . ...... .. . .. . . 31,640 34,163 Debt due within one year ................... 19 8 Long-term debt . . . . . . . . . . . . . . . . . . . . . . . . . . . 10,925 11,833 Borrowings against future stock option proceeds ......................... 895 533 Company-obligated mandatorily redeemable preferred securities of subsidiaries.. . . . . . . . . 575 575 Series M exchangeable prefened stock . . . . . . . - 1,857 Shareholders' equity: Preferred stock liquidation preference ...... 2,260 3,539 Equity applicable to common stock ........ 6,592 5,817 Total shareholders' equity . . . ... .. . . . . . . . . 8,852 9,356 Total capitalization . . . . . .. . . . . ... ... .. . .... 21,266 24,162 0 F-68 December 31, 1996 1995 (millions) $ 514 $ 1,185 35,064 22,132 11 34 12,713 9,907 488 - 949 949 1,672 - 3,559 2,994 5,943 673 9,502 3,667 25,335 14,557 1994 $ 282 16,716 355 8,839 � 140 1,008 1,148 10,342 Quarter 1998 lst ................ 2nd�a)cb) . . . . . . . . . . . . 3rd ................ 4ih�a)(b) ... . . . .. ... . Year�e��b� . . . . . . . . . . . 1997 lstt�)(d) ............ 2nd ............... 3rd�� .............. 4th�`��d� . .. . . .. . .. . . Year�`� �d� . . . . . . . . . . . TIME WARNER INC. QUARTERLY FINANCIAL INFORMATION (UNAUDITED) Net Equity Income Basic Diluted in Pretax (Loss) Income Income Operating Income Applicsble (Loss) Per (Loss) Per Dividends ]ncome of (Loss) of Net to Common Common Per Average Common Business Entertainment lncome Commoo S�are Share Common Common Stock(g) Revenues Segments Group (Loss) Shares(e) (e)(�(g) (e)(�(g) Share(g) Shares(g) High Low (millioos, except per �are amoaots) $ 3,137 $ 170 $107 $(62) $(144) $(0.12) $(0.12) $0.045 1,156.6 $37'/< $29'/�b 3,672 384 166 101 23 0.02 0.02 0.045 1,192.6 44'/�b 36'/�b 3,578 315 164 39 (37) (0.03) (0.03) 0.045 1,202.6 50 39 4,195 627 (81) 90 (214) (0.17) (0.17) 0.045 ],227.2 63'/s 37y�16 14,582 1,496 356 168 (372) (0.31) (0.31} 0.18 1,194.7 63'/e 29'/�� $ 3,034 $ 194 3,193 345 3,231 263 3,836 469 13,294 1,271 $318 $ 35 $ (43) 108 30 (49) 96 (35) (116) 164 216 135 686 246 (73) $(0.04) $(0.04) $0.045 (0.04) (0.04) 0.045 (0.t0) (O.10) 0.045 0.12 0.11 0.045 (0.06) (0.06) 0.18 1,117.8 $22'/x $18'/�b 1,122.0 25'/A 20'/, � 1,146.6 28'/�b 19'/< 1,155.0 31 26'/ 1,135.4 31 18'/�F (a) As indicated below, Time Warner's income (loss) per common share in 1998 has been dflected by certain significant nonrecurring items. These items consisted of gains and losses relating to the sale or exchange of various cable television systems and other investment-related activity and the efi'ect of redeeming 'Time Warner's Series M Preferred Stock. The aggregate net effect of these items in 1998 was to increase (decrease) income per common share by $.03 in the second quarter of 1998, and $(.28) in the fourth quarter of 1998, thereby aggregating $(.25) per common share for the year. (b) Time Warner's equity in the pretax income (loss) of the Entertainment Group for 1998 includes net gains of approximately $90 million for the year relating to the sale or exchange of certain cable television systems, of which approximately $70 million was recorded in the second quarter oF 1998. In addition, Time Warner's equity i� the pretax income (loss) of the Entertainment Group for the fourth quarter of 1998 includes a charge of approximately $210 million principally to reduce the carrying value of an intercst in Primestar. (c) Time Warner's income (loss) per common share in 1997 has been affected by certain significant nonrecurring items. 7'hese items consisted of net pretax gains relating to the sale or exchange of various cable television systems. and other investment-related activity and extraordinary losses on the retirement of debt. The aggregate net effect of these items in 1997 was to increase (decrease) income per common share by $.13 in the first quarter of 1997, $(.O1) in the third quarter of 1997 and $.15 in the founh quarter of 1997, thereby aggregating $.27 per common share for the year. Included in these amounts are eztraordinary losses on the retirement of debt of $17 million ($.02 per common share) in the first quarter of 1997, $7 million ($.O1 per common share) in the third quarter of 1997 and $31 million ($.02 per common share) in the fourth quarter of 1997. Also included in these amounts for the fourth quarter of 1997 is a$200 million pretax gain ($.10 per common sharo) relating to the disposal of Time Warner's interest in Hasbro and its related redemption of certain mandatorily redeemable preferred securities of a subsidiary. (d) Time Warner's equity in the pretax income of the Entertainment Group for the first quancr of 1997 includes an approximate $250 million pretax gain relating to the sale of TWE's interest in E! Entertainment. Time Warner's equity in the pretax income of the Entertainment Group for 1997 also includes net gains of approximately $200 million for the year relating to the ule or exchange of certain cable television systems, of which approximately $160 million wac recorded in the fourth quarter of 1997. (e) After preferred dividend requirements. Preferred dividend requirements for the fourth quarter of 1998 include a one-time increase of $234 million ($.19 loss per common share) relating to the premium paid in connection with the redemption of Time Warner's Series M Preferred Stock. (f) Per common share amounts for the quarters and full years have each been calculated separdtely. Accordingly, quarterly amounts may not add to the annudl amounts because of diflerences in the average common shares outstanding during each period and, with regard to diluted per common share amounts only, because of the inclusion of the effect of potentially dilutive securities only in the periods in which such etiect would have been dilutive. (g) Previously reponed amounts have been restated for the two-for-one common stock split that occurred on December I5, 1998. F-69 TIME WARNER INC. SUPPLEMENTARY INFORMATION CONDENSED CONSOLIDATING FINANCIAL STATEMENTS Time Warner Companies, Inc. ("TW Companies") and Turner Broadcasting System, Inc. ("TBS" and, together with TW Companies, the "Guarantor Subsidiaries") are wholly owned subsidiaries of Time Warner Inc. ("Time Warner"). Time Warner, TW Companies and TBS have fully and unconditionally guaranteed all of the outstanding publicly traded indebtedness of each other. Set forth below are condensed consolidating financial statements of Time Warner, including each of the Guarantor Subsidiaries, presented for the information of each company's public debtholders. Separate financial statements and other disclosures relating to the Guarantor Subsidiaries have not been presented because management has determined that this information would not be material to such debtholders. The following condensed consolidating financial statements present the results of operations, financial position and cash flows of (i) Time Warner, TW Companies and TBS (in each case, reflecting investments in its consolidated subsidiaries under the equity method of accounting), (ii) the direct and indirect non-guarantor subsidiaries of Time Warner and (iii) the eliminations necessary to arrive at the information for Time Warner on a consolidated basis. These condensed consolidating financial statements should be read in conjunction with the accompanying consolidated financial statements of Time Warner. Consolidating Statement of Operations For The Year Ended December 31, 1998 Revenues ................................ Cost of revenues�� . . . . . . . . . . . . . . . . . . . . . . . . Selling, general and administrative��......... Operating expenses ....................... Business segment operating income ............. ... .. ......... Equity in pretax income of consolidated subsidiaries . . . . . . . . . . . . . . . . . . Equity in pretax income of Entertainment Group.... .......................... Interest and other, net . . . . . . . . . . . . . . . . . . . . . Corporate expenses . . . . . . . . . . . . . . . . . . . . . . . Income before income taxes . . . . . . . . . . . . . . . . Income taxes ............................ Netincome .............................. Time TW Warner Companies $ — $ — 770 1,283 (98) (86) 586 �418) $ 168 (1) Includes depreciation and amortization expense of :........................... $ — TBS $ 720 303 211 514 206 327 Non- Time Guarantor Warner Subsitliaries Eliminations Consolidated (millions) $I3,886 $ (24) $14,582 7,931 (24) 8,210 4,665 — 4,876 12,596 (24) 13,086 1,290 — — 423 (55) (�16) ((64) 472 358 1,546 (322) �2) _�816) $ 150 $ 146 $ 730 $ — $ 9 $ 1,169 F-70 — 1,496 (2,380) — (67) 356 135) (1�(86) (2,376) 586 1,350 (418) $(1,026) $ 168 $ — $ 1,178 TIME WARNER INC. SUPPLEMENTARY INFORMATION CONDENSED CONSOLIDATING FINANCIAL STATEMENTS — (Continued) Consolidating Statement of Operations For The Year Ended December 31, 1997 Time TW Wamer Companies Revenues ................................ $ — $ — Cost of revenues�� . . . . . . . . . . . . . . . . . . . . . . . . — — Selling, general and administrative�' � . . . . . . . . . — — Operating expenses ....................... — — Business segment operating income............. . .... .......... — Equity in pretax income of consolidated subsidiaries . . . . . . . . . . . . . . . . .. . 922 Equity in pretax income of Entertainment Group. ............................. — Interest and other, net . . . . . . . . . . . . . . . . . . . . . (9) Corporate expenses ....................... (81) Income before income taxes . . . . . . . . . . . . . . . . 832 Income ta�ces ............................ 531) Income before extraordinary item . .. ............... ........ 301 Extraordinary loss on retirement of debt, net of tax................................... (55) Net income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 246 1,729 (994) (54) 681 (390) 291 (51) $ 240 Non- Time Guarantor Warner TBS Subsidiaries Eliminations Consolidated (millions) $ 523 $12,771 $ — $13,294 250 7,292 — 7,542 171 4,310 — 4,481 421 11,602 — 12,023 102 1,169 — 1,271 378 — (3,029) — — 727 (41) 686 (203) 211 (49) (1,044) �12) (60) 126 • (81) 265 2,047 (2,993) 832 175) 1,032) 1,597 (531) 90 1,015 (1,396) 301 (4) (51) 106 (55) $ 86 $ 964 $(1,290) $ 246 (1) Includes depreciation and amortization expense of :........................... $ — $ — $ 21 $ 1,273 $ — $ 1,294 F-71 TIME WARNER INC. SUPPLEMENTARY INFORMATION CONDENSED CONSOLIDATING FINANCIAL STATEMENTS — (Continued) Consolidating Statement of Operations For The Year Ended December 31, 1996 Time TW Warner Companies Revenues ................................. $ — $ — Cost of revenues�'� . . ... . ...... . . — Selling, general and administrative�' � . . . . . . . . . . — Operating expenses ........................ — Business segment operating income..... ..... ... ........... — Equity in pretax income of consolidated subsidiaries . . . . . . . . . . . . . . . . .. . . 156 Equity in pretax income of Entertainment Group. ........................... — Interest and other, net ...................... (16) Corporate expenses ........................ (17) Income (loss) before income taxes . . . . . . . . . . . 123 Income taxes ............................. �) Income (loss) before extraordinary item .... 59 Extraordinary loss on retirement of debt, net of tax.................................... — Net income (loss) . . . . . . . . . . . . . . . . . . . . . . . . . $ 59 � 776 (729) (62) (15) �13�) (145) (35) $(180) TBS $128 52 58 110 18 63 (29) (10) 42 (39) 3 $ 3 Non- Time Guarantor Warner Subsidiaries Eliminations Consolidated (millions) $9,936 $ — $10,064 5,870 — 5,922 3,118 — 3,176 8,988 — 9,098 948 — 966 — (995) — 290 — 290 (400) — (1,174) (64) 75 (78) 774 (920) 4 (494) 567 (160) 280 (353) (156) — — (35) $ 280 $(353) $ (191) (1) Includes depreciation and amortization expense of :............................ $ — $ — $ 6 $ 982 $ — $ 988 F-72 TIME WARNER INC. SUPPLEMENTARY INFORMATION CONDENSED CONSOLIDATING FINANCIAL STATEMENTS - (Continued) Consolidating Balance Sheet December 31, 1998 Non- Time Time TW Cuarantor Warner Waraer Companies TBS Subsidiaries Eliminations Consolidated (millions) ASSETS Current assets Cash and equivalents ............................... $ - Receivables, net .................................... 10 lnventories ........................................ - Prepaid expenses ................................... 17 Total current assets ................................. 27 Noncurrentinventories .............................. - lnvestments in and amounts due to and from consolidated subsidiaries ...................................... 15,222 Investments in and amounts due to and from Entertainment Group . . . . . . . . . . . . . . . . . . . . . . . . . . . . . - Otherinvestments .................................. 211 Property, plant and equipment, net . . . . . . . . . . . . . . . . . . . . 55 Music catalogues, contracts and copyrights . . . . . . . . . . . . . - Cable television and sports franchises . . . . . . . . . . . . . . . . . . - Goodwill.......................................... - Other assets ......................... ........... 65 Totalassets ....................................... $15,580 LIABILITIES AND SHAREHOLDERS' EQUITY Current liabilities Accounts payable .................................. $ 20 Participations, royalties and programming costs payable .................................... - Debt due within one year ............................ - Other current liabilities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 308 Total current liabilities . . . . . , . . . . . . . . . . . . . . . . . . . . . 328 Long-term debt .................................... 1,584 Debt due to affiliates ................................ - Borrowings against future stock option proceeds . . . . . . . . . 895 Deferred income taxes .............................. 3,491 Uneamed portion of paid subscriptions . . . . . . . .. . . . . . . . . - Other liabilities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 430 TW Companies-obligated mandatorily redeemable preferred securities of a subsidiary holding solely subordinated debentures of TW Companies. . . . . . . . . . . - Shareholders' equity Due to (from) Time Wamer and subsidiaries .................................. - Other shareholders' equity . . . . . . . . . . . . . . . . . . . . . . . . . . . 8,852 Total shareholders' equity . . . . . . . . . . . . . . . . . . . . . . . . . . . 8,852 Total liabilities and shareholders' equity . . .... .. .. . . .. .. $15,580 F-73 $ 66 56 5 127 $ 25 $ 351 78 2,750 13l 815 - 1,166 234 5,082 156 1,744 13,745 9,465 $ - (9) (12) �2�) ( 38,432) 919 - 4,169 (108 ) 15 24 1,194 (650) - 44 1,892 - - - 876 - - - 2,868 - - - 11,919 - 116 59 631 (8) $14,922 $ 9,982 $30,375 $(39,219) $ - $ 11 $ 965 $ - 229 229 7,346 3,324 31 176 218 747 1,647 246 116 1,168 19 1,705 3,857 1,248 158 3,570 741 997 575 (2,313) (479) (2,317) 6,336 7,487 21,546 4,023 7,008 19,229 $14,922 $ 9,982 $30,375 (14) (14) (1,805 ) (7,140) $ 442 2,885 946 1,176 5,449 1,900 4,980 794 1,991 876 2,868 11,919 863 $31,640 $ 996 1,199 19 2,404 4,618 10,925 895 3,491 741 1,543 - 575 5,109 - (35,369) 8,852 (30,260) 8,852 $(39,219) $31,640 TIME WARNER INC. SUPPLEMENTARY INFORMATION CONDENSED CONSOLIDATING FINANCIAL STATEMENTS - (Continued) Consolidating Balance Sheet December 31, 1997 Non- Time Time TW Cuarantor Waraer Warner Companies TBS Subsidiaries Eliminations Consolidated (millions) ASSETS Current assets Cash and equivalents ............................... $ - $ 372 $ 9 Receivables,net .................................... 34 82 9 Inventories ........................................ - - 112 Prepaid expenses ................................... 21 14 5 Total current assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 55 468 135 Noncurrentinventories .............................. - - 123 Investments in and amounts due to and from consolidated subsidiaries ...................................... 16,189 14,995 9,950 Investments in and amounts due to and from Entertainment Group . . . . . . . . . . . . . . . .. . . . . . . . . . . . . - 970 - Otherinvestments .................................. 106 1 24 Property, plant and equipment, net . . . . . . . . . . . . . . . . . . . . 68 - 48 Music catalogues, contracts and copyrights . . . . . . . . . . . . . - - - Cable television and sports franchises . . . . . . . . . . . . . . . . . . - - - Goodwill ...........................:.............. - - - Other assets ....................................... 54 124 118 'Total assets ....................................... $16,472 $16,558 $10,398 LIABILITIES AND SHAREHOLDERS' EQUITY Current liabilities Accounts payable .................................. $ 24 $ - $ 11 Participations, royalties and programming costs payable .................................... - - 10 Debt due within one year ............................ - - - Other current liabilities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 442 284 234 Total current liabilities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 466 284 255 Long-term debt .................................... - 8,462 747 Debt due to affiliates ..... . . . ... . . ... .. ...... . .... . . . - - 1,722 Borrowings against future stock option proceeds . . . . . . . . . 533 - - Deferred income taxes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3,960 3,797 243 Uneamed portion of paid subscriptions . .. .... .. . ..... . . - - - Otherliabilities .................................... 300 20 90 TW Companies-obligated mandatorily redeemable preferred securities of a subsidiary holding solely subordinated debentures of TW Companies. . . . . . . . . . . - - - Series M exchangeable preferred stock . . . . . . . . . . . . . . . . 1,857 - - Shareholders' equity Due to (from) 'Cime Warner and subsidiaries .................................. - (2,195) - Other shareholders' equity . . . . . . . . . . . . . . . . . . . . . . . . . . . 9,356 6,190 7,341 Total shareholders' equity . . . . . . . . . . . . . . . . . . . . . . . . . . . 9,356 3,995 7,34] Total liabilities and shareholders' equity .............. .. $16,472 $16,558 $10,398 F-74 $ 264 2,350 718 1,063 4,395 1,643 4,620 1,957 1,973 928 3,982 12,572 483 $32,553 $ 877 I ,062 8 1,371 3,318 2,624 158 4,040 672 596 $ - �z8) (14) (42) (41,134) (41) (593) (8) $(41,818) $ - 48 48 (1,880) ( 8,080) $ 645 2,447 830 1,089 5,011 1,766 5,549 1,495 2,089 928 3,982 12,572 771 $34,163 $ 912 1,072 8 2,379 4,371 11,833 533 3,960 672 1,006 575 - 575 - - 1,857 (256) 20,826 20,570 $32,553 2,451 (34,357) (31,906) $(41,818) 9,356 9,356 $34,163 TIME WARNER INC. SUPPLEMENTARY INFORMATION CONDENSED CONSOLIDA'ITNG FINANCIAL STATEMENTS — (Continued) Consolidating Statement of Cash Flows For The Year Ended December 31, 1998 Non- Time Time TW Guarantor Warner Warner Companies TBS Subsidiaries Eliminations Consolidated (millions) OPERATIONS Net income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 168 $ 150 Adjustments for noncash and nonoperating items: Depreciation and amortization . . . . . . . . . . . . . . . . . . . . . . . . . . — — Noncashinterest expense .............................. — 30 Excess (deficiency) of distributions over equity in pretax income of consolidated subsidiaries ... .. .. . . .. .. . . .. . . . 1,767 (666) Excess of distributions over equity in pretax income of Entertainment Group . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . — — Equity in losses of other investee companies after distributions — — Changes in operaeng assets and liabilities . . . . . . . . . . . . . . . . . . 212 2,869 Cash provided by operations ............................ 2,147 2,383 INVESTING ACTIViTIES i • d• $ 146 $ 730 9 1,169 374 — (426) 103 nvestments an acquisitions ............................ (213) — — Advances to parents and wnsolidated subsidiaries.......... — (2,716) — Repayments of advances from consolidated subsidiaries ..... 75 — — Capitalexpenditures ................................... — — (12) Investment proceeds .................................. — — — PTOCeeds received from distribution of TWE Senior Capital — — — Cash provided (used) by investing activities .............. (138) (2,716) (12) FINANCING ACTIVITIES Borrowings .......................................... 1,584 498 Debt repayments ..................................... — (500) Change in due to/from parent . .. .. ... ... .. . ... . ..... .. . 220 43 Borrowings against future stock option proceeds . . . . . . . . . . . 1,015 — Repayments of borrowings against future stock option proceeds ........................................... (653) — Repurchases of Time Warner common stock . . . . . . . . . . . . . . (2,240) — Redemption of Series M Preferred Stock ... .. ..... ... .. .. . (2,093) — Dividends paid ....................................... (524) — Proceeds received from stock option and dividend reinvestment plans .................................. 740 — Other, principally financing costs . ........ ............... (58) (14) Cash provided (used) by financing activities . .. . . ... ... .. . (2,009) 27 INCREASE (DECREASE) IN CASH AND EQUIVALENTS .................... ............... — (306) CASH AND EQUIVALENTS AT BEGINNING OF PERIOD .......................................... — 372 CASH AND EQUIVALENTS AT END OF PERIOD .....$ — $ 66 F-75 275 90 (538) 1,726 54 (263) (500) 569 455 315 — 1,661 (75) (1,817) — (1,798) (75) (1,954) 16 87 9 264 $ 25 $ 351 $ (1,026) $ 168 — 1,178 — 30 (1,475) — 67 57 (2,137) (4,514) 2,979 (75) 2,904 342 147 (20) 1,845 (]59) (512) 569 455 353 — 3,743 75 (2,317) 1,535 — — 1,O15 — (653) — (2,240) — (2,093) — (524) — 740 — (72) 1,610 (2,401) — (203) — 645 $ — $ 442 TIME WARNER INC. SUPPLEMENTARY INFORMATION CONDENSED CONSOLIDATING FINANCIAL STATEMENTS — (Continued) Consolidating Statement of Cash Flows For The Year Ended December 31, 1997 Non- Time Time TW Guarantor Warner Warner Companies TBS Subsidiaries Eliminations Consolidated (millions) OPERATIONS Net income .......................................... $ 246 $ 240 $ 86 $ 964 Adjustments for noncash and nonoperating items: Extraordinary loss on retirement of debt . . . . . . . . . . . . . . . . . . . 55 51 4 51 Depreciation and amortization .......................... — — 2� ��273 Noncash interest expense .........................:.... — 95 3 — Excess of distributions over equity in pretax income of consolidated subsidiaries ............................. 558 89 119 — Deficiency of distributions over equity in pretax income of Entertainment Group ............................... — — — (248) Equity in losses (income) of other investee companies after distributions ....................................... — — — (9) Changes in operating assets and liabilities . . . . . . . . . . .. .. . . (95) 633 13 (668) Cash provided by operaiions ............................ 764 1,108 246 ],363 INVESTING ACTIVITIES Investments and acquisitions . . . . . . . . . . . . . . . . . . . . . . . . . . . (19) — — (94) Advancesto parents and consolidated subsidiaries ......... (778) (134) — (113) Repayments of advances from consolidated subsidiaries ..... 41 — — 38S Capitalexpenditures .................................. — — (11) (563) Investment proceeds .................................. — — — 187 Proceeds received from distribution of TWE Senior Capital — — — 455 Cash provided (used) by investing activities . . . . . . . . . . . . . . (756) (134) (11) 257 FINANCING AC'TIVITIES Borrowings .......................................... — 2,443 737 3,104 Debtrepayments ..................................... — (1,887) (963) (3,544) Change in due to/from parent .......................... 113 (1,281) — (1,177) Borrowings against future stock option proceeds . . . . . . . . . . . 230 — — — Repayments of borrowings against future stock option proceeds .......................................... (185) Repurchases of Time Warner common stock . . . . . . . . . . . . . . (344) — — — Dividends paid ....................................... (338) — — — Proceeds received from stock option and dividend reinvestment plans .................................. 454 — — — Other, principally financing costs . . . . . . . . . . . . . . . . . . . . . . . . — (14) — ( 54) Cash used by financing activities . . . . . . . . . . . . . . . . . . . . . . . . (70) (739) (226) (1,671) INCREASE (DECREASE) IN CASH AND EQUIVALENTS ................................... (62) 235 9 (51) CASH AND EQUIVALENTS AT BEGINN(NG OF PERIOD .......................................... 62 137 — 315 CASH AND EQUIVALENTS AT END OF PERIOD..... $— $ 372 $ 9 $ 264 F-76 $(1,290) $ 246 (106) 55 — 1,294 — 98 (766) — 41 (207) 45 3 ( 2,073 ) I ,025 (426) 599 36 (114) 1,408 (113) (574) 187 455 (45) (871) 5,413 — (6,394) 2,345 — — 230 — (185) — (344) — (338) — 454 — (68) 1,474 (1,232) — 131 — 514 $ — $ 645 TIME WARNER INC. SUPPLEMENTARY INFORMATION CONDENSED CONSOLIDATING FINANCIAL STATEMENTS — (Continued) Consolidating Statement of Cash Flows For The Year Ended December 31, 1996 Non- Time Time TW Guarantor Warner Warner Compaaies TBS Subsidiaries Eliminatioas Consolidated (millions) OPERATIONS Netincome (loss) .................................. $ 59 $ (180) $ 3 Adjustments for noncash and nonoperating items: Extraordinary loss on retirement of debt . . . . . . . . . . . . . . . . . — 35 — Depreciation and amortization . . . . . . . . . . . . . . . . . . . . . . . . — — 6 Noncash interest expense ............................ — 91 5 Excess (deficiency) of distributions over equity in pretax income of consolidated subsidiaries ............ ... ... 213 (330) 91 Deficiency of distributions over equity in pretax income of Entertainment Group . . . . . . . . . . . . . .. . . . . . . .. . . . . . . — — — Equity in income of other investee companies after distributions ..................................... — — — Changes in operating assets and liabilities . . .. .. .. . . . . . . 35 530 (27) Cash provided by operations ......................... 307 146 78 INVESTING ACTIVITIES lnvestments and acquisitions . . . . . . . . . . . . . . . .. . . . . . . . . 58 — — Advances to parents and consolidated subsidiaries ....... (1,300) (155) — Repayments of advances from consolidated subsidiaries .. 1,000 — — Capital expenditures ................................ — — (5) Investment proceeds ................................ — — — Cash used by investing activities . . . . . . . . . . . . .. . . . . . . . . (242) (155) (5) FINANCING ACTIVITIES Borrowings ........................................ — 864 985 Debt repayments ..:................................ — (1,634) (1,058) Change in due to/from parent ........................ — (1,349) — Borrowings against future stock option proceeds . . . . . : . . . 63 425 — Repurchases of Time Warner common stock . . . . . . . . . . . (4) (452) — Issuance of Series M Preferred Stock ................. — 1,550 — Dividends paid, .................................... (84) (203) — Proceeds received from stock option and dividend reinvestment plans ................................ 22 83 — Other, principally financing costs . . . . . . . . . . . .. . . . . . . . . — (60) — Cash provided (used) by financing activities............ (3) (776) (73) INCREASE (DECREASE) IN CASH AND EQUIVALENTS ................................. 62 (785) — CASH AND EQL3IVALENTS AT BEGINNING OF PERIOD ....................................... — 922 — CASH AND EQUIVALENTS AT END OF PERIOD .. $ 62 $ 137 $ — F-77 $ 280 $ (353) $ (191) — — 35 982 — 988 — — � 96 — 26 — (62) — (b2) (53) — (53) (685) (413) (560) 462 (740) 253 (293) (26) (261) — 1,455 — — (1,000) — (476) — (481) 318 — 3i8 (451) 429 (424) 2,591 ( 2,579) 29 � � 52 263 $ 315 (1,009) 1,320 3,431 (5,271) 488 (456) 1,550 (287) — 105 — (60) 311 (500) — (671) — 1,185 $ — $ 514 Description TIME WARNER INC. SCHEDULE II — VALUATION AND QUALIFYING ACCOUNTS Years Ended December 31, 1998, 1997 and 1996 Additions Balance at Charged to Beginning Costs and of Period Expenses Deductions (millions) 1998: � Reserves deducted from accounts receivable: Allowance for doubtful accounts . . . . . . . . . . . . . . . $ 311 Reserves for sales retums and allowances ........ 680 Tota! ........................................ $ 991 Reserves deducted from amounts due to publishers (accounts payable) Allowance for magazine and book returns . . . . . . . $ (171) 1997: Reserves deducted from accounts receivable: Allowance for doubtful accounts . . . . . . . . . . . . . . . $ 236 Reserves for sales retums and allowances ........ 740 Total........................................ $ 976 Reserves deducted from amounts due to publishers (accounts payable) Allowance for magazine and book returns . . . . . . . $ (179) 1996: Reserves deducted from accounts receivable: Allowance for doubtful accounts . . . . . . . . . . . . . . . $ 188 Reserves for sales returns and allowances ........ 598 Total........................................ Reserves deducted from amounts due to publishers (accounts payable) Allowance for magazine and book returns ....... $ 786 $(163) Balance At End of Period $ 323 $ (318) �`� $ 316 2,490 (2,479)�d��`� 691 $ 2,813 $(2,797) $1,007 $(1,206) $ 1,157�e� $ (220) $ 379 $ (304)�`� $ 311 2�599 (2,659)�d��`� 680 $ 2,978 $ 2,963) $ 991 $ (1,070) $ 1,078�`� $ (171) $ 312�a� $ (264) �`� $ 236 2,628�b� (2,486)(d)(`) 740 $ 2,940 $ 2,750) $ 976 $(1,023) $ 1,007�`� $ (179) (a) Includes $40 million charged to other accounts in connection with the allocation of Time Warner's cost to acquire the remaining 80% interest in TBS that it did not already own. (b) Includes $21 million charged to other accounts in connection with the allocation of Time Warner's cost to acquire the remaining 80% interest in TBS that it did not already own. (c) Represents uncollectible receivables charged against reserve. (d) Represents returns or allowances applied against reserve. (e) The distribution of magazines and books not owned by Time Warner results in a receivable recorded at the sales price and a cottesponding liability to the publisher recorded at the sales price less the distribution comm'ission recognized by Time Warner as revenue. Therefore, it would be misleading to compare magazine and book revenues to the provision charged to the reserve for magazine and book returns that is deducted from accounts receivable without also considering the related offsetting activity in the reserve for magazine dnd book returns that is deducted from the liability due to the publishers. F-78 TIME WARNER ENTERTAINMENT COMPANY, LP. MANAGEMENT'S DISCUSSION AND ANALYSIS OF RESULTS OF OPERATIONS AND FINANCIAL CONDITION Description of Business Time Warner Entertainment Company, L.P. ("TWE" or the "Company") classi�ies its business interests into three fundamental areas: Cable Networks, consisting principally of interests in cable tele�ision program- ming; Entertainment, consisting principally of interests in filmed entertainment, television production and television broadcasting; and Cable, consisting principally of interests in cable television systems. TWE also manages the cable properties owned by Time Warner and the combined cable television operations are conducted under the name of Time Warner Cable. Use of EBITA TWE evaluates operating performance based on several factors, of which the primary financial measure is operating income before noncash amorEization of intangible assets ("EBITA"). Consistent with manage- ment's financial focus on controlling capital spending, EBITA measures operating performance after charges for depreciation. In addition, EBITA eliminates the uneven effect across all business segments of considerable amounts of noncash amortization of intangible assets recognized in business combinarions accounted for by the purchase method, including Time Warner's $14 billion acquisition of Wamer Communications Inc. in 1989 and $1.3 billion acquisition of the minority interest in American Television and Communications Corporation in 1992. The exclusion of noncash amortization chazges also is consistent with management's belief that TWE's intangible assets, such as cable television franchises, film and television libraries and the goodwill associated with its brands, generally are increasing in value and importance to TWE's business objective of creating, extending and distributing recognizable brands and copyrights throughout the world. As such, the following comparative discussion of the results of operations of TWE includes, among other factors, an analysis of changes in business segment EBITA. However, EBITA should be considered in addition to, not as a substitute for, operating income, net income and other measures of financial performance reported in accordance with generally accepted accounting principles. Transactions Af%cting Comparability of Results of Operations As more fully described herein, the comparability of TWE's operating results has been affected by certain significant transactions and nonrecurring items in each period. For 1998, these significant transactions related to TWE's cable business and included (i) the transfer of cable television systems (or interests therein) serving approximately 650,000 subscribers that were formerly owned by subsidiaries of Time Warner to the TWE-Advance/Newhouse Partnership ("TWE-A/N"), subject to approximately $1 billion of debt, in exchange for common and preferred partnership interests in TWE-A/N, as well as certain related transactions (collectively, the "TWE-A/N Transfers"), (ii) the transfer of TWE's and TWE-A/N's direct broadcast satellite operations and related assets to Primestar, Inc. ("Primestar"), a separate holding company (the "Primestar Roll-up Transaction"), (iii) the reorganization of Time Warner Cable's Time Warner Telecom operations into a sepazate entity named Time Warner Telecom LLC (the "Time Warner Telecom Reorganization") and (iv) the formation of a joint venture to operate and expand Time Warner Cable's and MediaOne Group Inc.'s ("MediaOne") e�cisting high-speed online businesses (the "Road Runner Joint Venture" and collectively, the "1998 Cable Transactions"). In addition, there were a number of other significant, nonrecurring items recognized in 1998 and 1997, consisting of (i) net pretax gains in the amount of approximately $90 million in 1998 and $200 million in 1997 relating to the sale or exchange of various cable television systems, (ii) a pretax gain of approximately $250 million in 1997 relating to the sale of its interest in E! Entertainment Television, Inc. ("E! Entertainment"), (iii) a charge of approximately $210 million in 1998 principaily to reduce the cazrying value of its interest in Primestar and (iv) an extraordinary loss of $23 million in 1997 on the retirement of debt. F-79 TIME WARNER ENTERTAINMENT COMPANY, LP. MANAGEMENT'S DISCUSSION AND ANALYSIS OF RESULTS OF OPERATIONS AND FINANCIAL CONDITION —(Continued) In order to meaningfully assess underlying operating trends, management believes that the results of operations for 1998 and 1997 should be analyzed after excluding the effects of these significant nonrecurring items. As such, the following discussion and analysis focuses on amounts and trends adjusted to exclude the impact of these unusual items. However, unusual items may occur in any period. Accordingly, investors and other financial statement users individually should consider the types of events and transactions for which adjustments have been made. RESULTS OF OPERATIONS 1998 vs. 1997 EBITA and operating income in 1998 and 1997 are as follows: Filmed Entertainment-Wamer Bros . . . . . . . . . . . . . . . . . Broadcasting-The WB Network . . . . . . . . . . . . . . . . . . . . Cable Networks-HBO . . . . . . . . . . . . . . Cable�� ........................................ Years Ended December 31, EBITA Operating Income 1998 1997 1998 1997 (millions) $ 498 $ 387 $ 369 $ 264 (93) (88) (96) (88) 454 391 454 391 1,369 Total.......................................... $2,228 1,184 $1,874 992 877 $1,719 $1,444 (1) Includes net gains of approximately $90 million and $200 million recognized in 1998 and 1997, respectively, related to the sdle or exchange of certain cable television systems. TWE had revenues of $12.246 billion and net income of $326 million for the year ended December 31, 1998, compared to revenues of $11.318 billion, income of $637 million before an extraordinary loss on the retirement of debt and net income of $614 million for the year ended December 31, 1997. As previously described, the comparability of TWE's operating results for 1998 and 1997 has been affected by certain significant nonrecurring items recognized in each period, consisting of gains and losses relating to the sale or exchange of cable television systems and other investment-related activity. These nonrecurring items amounted to approximately $120 million of net pretax losses in 1998, compared to approximately $450 million of net pretax gains in 1997. In addition, net income in 1997 included an extraordinary loss on the retirement of debt of $23 million. TWE's net income decreased to $326 million in 1998, compared to $614 millicn in 1997. However, excluding the significant effect of ihe nonrecurring items referred to above, net income increased by $229 million to $460 million in 1998, compared to $231 million in 1997. As discussed more fully below, this improvement principally resulted from an overall increase in TWE's business segment operating income (including the positive effect of the TWE-A/N Transfers), offset in part by an increase in interest expense associated with the TWE-A/N Transfers and higher losses from certain investments accounted for under the equity method of accounting. As a U.S. partnership, TWE is not subject to U.S. federal and state income taxation. Income and withholding taxes of $92 million in the year ended December 31, 1998, and $85 million in the year ended December 31, 1997, have been provided for the operations of TWE's domestic and foreign subsidiary corporations. Filmed Entertainment-Warner Bros. Revenues increased to $6.051 billion, compared to $5.462 billion in 1997. EBITA increased to $498 million from $387 million. Operating income increased to $369 million F-80 TIME WARNER ENTERTAINMENT COMPANY, LP. MANAGEMENT'S DISCUSSION AND ANALYSIS OF RESULTS OF OPERATIONS AND FINANCIAL CONDITION —(Continued) from $264 million. Revenues benefited from a significant increase in licensing fees from television production and distribution operations, principally relating to the initial off-network domestic syndication availability of Friends and the initial off-network basic cable availability of ER, as well as an increase in revenues from consumer products licensing operations. EBITA and operating income benefited principally from the revenue gains and cost savings, offset in part by lower international syndication sales of library product and lower results from theatrical releases. In addition, EBITA and operating income for each period included certain one-time gains on the sale of assets that were comparable in amount and therefore, did not have any significant effect on operating trends. Broadcasting-The WB Network. Revenues increased to $260 million, compared to $136 million in 1997. EBITA decreased to a loss of $93 million from a loss of $88 million. Operating losses increased to $96 million from $88 million. Revenues increased as a result of higher adverrising sales relating to improved television ratings and the addition of a fourth night of prime-time programming in January 1998 and a fifth night in September 1998. Despite the revenue increase, operating losses increased because of a lower allocation of losses to a minority partner in the network. However, excluding this minority interest effect, operating losses improved principally as a result of the revenue gains, which outweighed higher programming costs associated with the expanded programming schedule. Cable Nerworks-HBO. Revenues increased to $2.052 billion, compazed to $1.923 billion in 1997. EBITA and operating income increased to $454 million from $391 million. Revenues benefited primarily from an increase in subscriptions to 34.6 aullion from 33.6 million at the end of 1997. EBITA and operating income improyed principally as a result of the revenue gains and, to a lesser extent, cost savings and higher income from Comedy Central, a 5096-owned equity investee. Cable. Revenues increased to $4.378 billion, compared to $4.243 billion in 1997. EBITA increased to $1.369 billion from $1.184 billion. Operating income increased to $992 million from $877 million. The Cable division's 1998 operating _results were pc�sitively a{%cted by the aggregate net impact of the 1998 Cable Transactions. Excluding the effect of the 1998 Cable Transactions, revenues increased principally as a result of an increase in basic cable subscribers, increases in regulated cable rates and an increase in . advertising revenues. Similazly excluding the effect of the 1998 Cable Transactions, EBITA and operating income increased principally as a result of the revenue gains, offset in part by higher depreciation related to capital spending and approximately $110 million of lower, net pretax gains relating to the sale or exchange of certain cable television systems. As of December 31, 1998, including the cable operations of TWE-A/N and Time Warner, there were 12.6 million subscribers under the management of TWE's Cable division, as compared to 12.0 million subscribers at the end of 1997. The number of subscribers at the end of 1997 excludes all direct broadcast satellite subscribers that were trausferred to Primestar in 1998 in connection with the Primestar Roll-up Transaction. Inrerest and Other, Ner. Interest and other, net, increased to $965 million, compazed to $345 million in 1997. Interest expense increased to $566 million, compared to $490 million in 1997 principally due to higher average debt levels associated with the T'WE-A/N Transfers. There was other expense, net, of $399 million in 1998, compared to other income, net, of $145 million in 1997, primarily due to lower investment-related income, as well as higher losses associated with TWE's asset securitization program. The significant decrease in investment-related income principally resulted from the absence of an approximate $250 million pretax gain recognized in 1997 in connection with the sale of an interest in E! Entertainment, the inclusion of an approximate $210 million charge recorded in 1998 principally to reduce the cariying value of an interest in Primestar and higher losses in 1998 from certain investments accounted for under the equity method of accounting. F-81 TIME WARNER ENTERTAINMENT COMPANY, LP. MANAGEMENT'S DISCUSSION AND ANALYSIS OF RESULTS OF OPERATIONS AND FINANCIAL CONDITION —(Continued) 1997 vs. 1996 EBITA and operating income in 1997 and 1996 are as follows: Years Ended December 31, EBITA Operating Income 1997 19% 1997 1996 (millions) Filmed Entertainment-Warner Bros . . . . . . . . . . . . . . . . . $ 387 $ 367 $ 264 $ 242 Broadcasting-The WB Network . . . . . . . . . . . . . . . . . . . . (88) (98) (88) (98) Cable Networks-HBO . . . . . . . . . . . . . . . . . . . . . . . . . . . . 391 328 391 328 Cable�'� .................. ................... 1,184 917 877 606 Total .......................................... $1,874 $1,514 $1,� $1,078 (i) Includes net gains of approximately $200 million recognized in 1997 related to the sale or exchange of certain cable television systems. TWE had revenues of $11.318 billion, income of $637 million before an extraordinary loss on the retirement of debt and net income of $614 million for the year ended December 31, 1997, compared to revenues of $10.852 billion and net income of $210 million for the year ended December 31, 1996. As previously described, the comparability of TWE's operating results for 1997 and 1996 has been affected by certain significant nonrecurring items recognized in 1997, consisting of net pretax gains relating to the sale or exchange of cable television systems and other investment-related activity. These nonrecurring items amounted to approximately $450 million of net pretax gains in 1997. In addition, net income in 1997 included an extraordinary loss on the rerirement of debt of $23 million. TWE's net income increased to $614 million in 1997, compared to $210 million in 1996. Excluding the significant effect of the nonrecurring items referred to above, net income increased by $21 million to $231 million in 1997, compared to $210 million in 1996. As discussed more fully below, this improvement principally resulted from an overall increase in EBITA and operaring income generated by TWE's business segments, offset in part by an increase in minority interest expense related to TWE-A/N. As a U.S. partnership, TWE is not subject to U.S. federal and state income taxation. Income and withholding taxes of $85 million in the year ended December 31, 1997, and $70 million in the year ended December 31, 1996, have been provided for the operations of TWE's domestic and foreign subsidiary corporations. Filmed Entertainment-Warner Bros. Revenues decreased to $5.462 billion, compared to $5.639 billion in 1996. EBITA increased to $387 million from $367 million. Operating income increased to $264 million from $242 million. Revenues decreased principally as a result of lower worldwide theatrical and home video revenues, offset in part by increases in worldwide television distribution revenues. EBITA and operating income increased principally as a result of high-margin sales of library product that contributed to the strong performance of worldwide television distribution operations, cost savings and certain one-time gains, offset in part by higher depreciation principally relating to the expansion of theme parks and consumer products operations. Broadcasting-The WB Network. Revenues increased to $136 million, compared to $87 million in 1996. EBITA and operating losses improved to a loss of $88 million from a loss of $98 million. The increase in revenues primarily resulted from the expansion of programming in September 1996 to three nights of prime- time scheduling and the expansion of Kids' WB!, the network's animated programming lineup on Saturday F-82 TIME WARNER ENTERTAINMENT COIV�PANY, LP. MANAGEMENT'S DISCUSSION AND ANALYSIS OF RESULTS OF OPERATIONS AND FINANCIAL CONDITION —(Continued) mornings and weekdays. The 1997 operating loss improved principally as a result of the revenue gains and the effect of an increase in a limited partner's interest in the network that occurred in early 1997. Cable Networks-HBO. Revenues increased to $1.923 billion, compared to $1.763 billion in 1996. EBITA and operating income increased to $391 million from $328 million. Revenues benefited primarily from an increase in subscriptions to 33.6 million from 32.4 million at the end of 1996. EBITA and operating income improved principally as a result of the revenue gains and, to a lesser extent, cost savings. Cable. Revenues increased to $4.243 billion, compared to $3.851 billion in 1996. EBITA increased to $1.184 billion from $917 million. Operating income increased to $877 million from $606 million. Revenues benefited from an increase in basic cable and Primestaz-related, direct broadcast satellite subscribers, increases in regulated cable rates and an increase in advertising and pay-per-view revenues. EBITA and operating income increased principally as a result of the revenue gains, as well as net gains of approximately $200 million recognized in 1997 in connection with the sale or exchange of certain cable systems. The increases in EBITA and operating income were partially offset by higher depreciation relating to capital spending. As of December 31, 1997, including Primestar-related, direct broadcast satellite subscribers and the cable operations of TWE-A/N and Time Warner, there were 12.6 million subscribers under the management of TWE's Cable division, as compared to 12.3 million subscribers at the end of 1996. Interest and Other, Net. Interest and other, net, decreased to $345 million, compared to $522 million in 1996. Interest expense increased to $490 million, compared to $475 million in 1996. There was other income, net, of $145 million in 1997, compared to other expense, net, of $47 million in 1996, principally due to higher gains on asset sales, including an approximate $250 million pretax gain on the sale of an interest in E! Entertainment recognized in 1997. This income was offset in part by higher losses from reductions in the carrying value of certain investments and the dividend requirements on preferred stock of a subsidiary issued in February 1997. FIlVANCIAL CONDITION AND LIQUIDTTY December 31, 1998 1998 Financial Condition At December 31, 1998, TWE had $6.6 billion of debt, $87 million of cash and equivalents (net debt of $6.5 billion), $217 million of preferred stock of a subsidiary, $603 million of Time Warner General Partners' Senior Capital and $5.1 billion of partners' capital, compazed to $6.0 billion of debt, $322 million of cash and equivalents (net debt of $5.7 billion), $233 million of preferred stock of a subsidiary, $1.1 billion of Time Warner General Partners' Senior Capital and $6.3 billion of partners' capital at December 31, 1997. Net debt increased in 1998 principally as a result of the TWE-A/N Transfers and increased borrowings to fund cash distributions paid to Time Warner, partially offset by approximately $650 million of debt reduction associated with the formation of a cable television joint venture in Texas (the "Te�cas Cable Joint Venture") with TCI Communications, Inc. ("TCI"), a subsidiary of Tele-Communications, Inc. Credit Statistics TWE's financial rarios, consisting of commonly used financial measures such as leverage and coverage ratios, are used by credit rating agencies and other credit analysts to measure the ability of a company to repay debt (leverage) and to pay interest (coverage). The leverage ratio represents the ratio of total debt, less cash to total business segment operating income before depreciation and amortization, less corporate expenses F-83 TIME WARNER ENTERTAINMENT COMPANY, L.P. MANAGEMENI"S DISCUSSION AND ANALYSIS OF RESULTS OF OPERATIONS AND FIIVANCIAL CONDITION —(Continued) ("Adjusted EBITDA"). 'The coverage ratio represents the ratio of Adjusted EBITDA to total interest expense. Those ratios are set forth below: t99s Leverage ratio ................................................. 2.1x Interest coverage ratio�'� . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5.3x (a) lncludes dividends relxted to the preferred stock of a subsidiary. Cash Flows 1997 1996 2.1 x 2.4x 5.4x 4.7x In 1998, TWE's cash provided by operations amounted to $2.288 billion and reflected $2.228 billion of EBITA from the Filmed Entertainment-Warner Bros., Broadcasting-The WB Network, Cable Networks- HBO and Cable businesses, $927 million of noncash depreciation expense and $166 million from the securitization of backlog, less $537 million of interest payments, $91 million of income taxes, $72 million of corporate expenses and $333 million related to an increase in working capital requirements, other balance sheet accounts and noncash items. Cash provided by operations of $1.834 billion in 1997 reflected $1.874 billion of business segment EBITA, $940 million of noncash depreciation expense and $300 million from the securirization of backlog, less $493 million of interest payments, $95 million of income taxes, $72 million of corporate expenses and $620 million related to an increase in working capital requirements, other balance sheet accounts and noncash items. Cash used by investing activiries was $745 million in 1998, compared to $1.252 billion in 1997, principally as a result of a$761 million increase in investment proceeds, offset in part by a reducrion of cash flows from investments and acquisitions related to the deconsolidation of approximately $200 million of cash of Paragon Communications in connecrion with the TWE-A/N Transfers. Investment proceeds increased principally due to TWE's debt reduction efforts, including proceeds from the sale of TWE's remaining interest in Six Flags Entertainment Corporation and the receipt of approximately $650 million of proceeds upon the formation of the Texas Cable Joint Venture with TCI. Capital expenditures were $1.603 billion in 1998, and $1.565 billion in 1997. Cash used by financing acrivities was $1.778 million in 1998, compared to $476 million in 1997. The use of cash in 1998 principally reflected $1.153 billion of distributions paid to Time Warner and the use of investment proceeds to reduce debt in connection with TWE's debt reduction ef%rts. The use of cash in 1997 principally reflected $934 million of distributions paid to Time Warner, offset in part by $243 million of aggregate net proceeds from the issuance of prefened stock of a subsidiary and an increase in borrowings used to fund cash distriburions to Time Wamer. Management believes that TWE's operating cash flow, cash and equivalents and additional borrowing capacity are sufficient to fund its capital and liquidity needs for the foreseeable future. Cable Capital Spending Time Warner Cable has been engaged in a plan to upgrade the technological capability and reliability of its cable television systems and develop new services, which it believes will keep the business positioned for sustained, long-term growth. Capital spending by TWE's Cable division amounted to $1.451 billion in 1998, compared to $1.401 billion in 1997. Capital spending by TWE's Cable division for 1999 is budgeted to be approximately $1.2 billion and is expected to continue to be funded by cable operating cash flow. In exchange for certain flexibility in establishing cable rate pricing structures for regulated services and consistent with Time Warner Cable's long-term strategic plan, Time Warner Cable agreed with the Federal Communications Commission (the "FCC") in 1996 to invest a total of $4 billion in capital costs in connection with the upgrade F-84 TIME WARNER ENTERTAINMENT COMPANY, LP. MANAGEMENT'S DISCUSSION AND ANALYSIS OF RESULTS OF OPERATIONS AND FINANCIAL CONDITION —(Continued) of its cable infrastructure. The agreement with the FCC covers all of the cable operations of Time Warner Cable, including the owned or managed cable television systems of TWE, TWE-A/N and Time Warner. As of December 31, }998, Time Warner Cable had approximately $1 billion remaining under this commitment, of which approximately $700 million is expected to be incurred for the upgrade of TWE's and TWE-A/N's owned and managed cable television systems. Management expects to satisfy this commitment by Decem- ber 31, 2000 when Time Warner Cable's technological upgrade of its cable television systems is scheduled to be substantially completed. Cabie Strategy In addition to using cable operating cash flow to finance the level of capital spending necessary to upgrade the technological capability of cable television systems and develop new services, Time Wamer, TWE and TWE-A/N have completed or announced a series of transactions over the past year related to the cable television business and related ancillary businesses. These transactions consist of the TWE-A/N Transfers, the Primestar Roll-up Transaction, the Time Wamer Telecom Reorganization, the formation of the Road Runner Joint Venture, the formation of the Texas Cable Joint Venture and other TCI-related cable transactions and the anticipated formation with AT&T Corp. ("AT&T") of a cable telephony joint venture (the "AT&T Cable Telephony Joint Venture"). Except for the TWE-A/N Transfers, these transactions have reduced, or will reduce, either existing debt and/or TWE's share of future funding requirements for these businesses. In addition, the formation of the Road Runner Joint Venture and, ultimately, the AT&T Cable Telephony Joint Venture, when completed, will enable Time Warner Cable to leverage its technologically advanced, high-capacity cable architecture into new opportunities to create incremental value through the development and exploitation of new services with strategic partners, such as AT&T, Microsoft Corp. and Compaq Computer Corp. The proposed AT&T Cable Telephony Joint Venture is discussed more fully below and the other transactions are described in Note 2 to the accompanying consolidated financial statements. AT&T Cable Telephony Joint Venture In February 1999, Time Warner, TWE and AT&T announced their intention to form a strategic joint venture. This joint venture will offer AT&T-branded cable telephony service to residential and sma11 business customers over Time Warner Cable's television systems for up to a twenty-year period. T'his transaction ef%ctively will allow Time Warner Cable to leverage its existing cable infrastructure into a new growth opportunity in a non-core business, without the need for any incremental capital investment. Under the preliminary terms announced by the parties, the joint venture will be owned 22.59b by Time Warner Cable and 77.596 by AT&T. AT&T will be responsible for funding all of the joint venture's negative cash flow and Time Warner Cable's equity interest in the joint venture will not be diluted as a result of AT&T's funding obligations. Because AT&T is expected to have significant funding obligations through at least the first three years of the joint venture's operations when capital will be deployed and services first rolled-out, Time Warner Cable expects to benefit from the additional value created from its "carried" interest. In addition to its equity interest, Time Warner Cable is expected to receive the following payments from the joint venture: (i) Approximately $300 million of inirial access fees, based on a rate of $15 per home passed that is payable in two annual installments once a pazticular service area has been upgraded and powered for cable telephony service. Time Warner Cable is expected to receive additional access fees in the future as its cable television systems continue to pass new homes. F-85 TIME WARNER ENTERTAINMENT COMPANY, L.P. MANAGEMENT'S DISCUSSION AND ANALYSIS OF RESULTS OF OPERATIONS AND FIlVANCIAL CONDITION —(Continued) (ii) Recurring monthly subscriber fees in the initial amount of $1.50 per telephony subscriber, to be adjusted periodically to up to $6.00 per telephony subscriber in the sixth year of providing cable telephony service to any particular area. In addition, the joint venture is expected to guarantee certain minimum penetration levels to Time Warner Cable, ranging from 5% in the second year of providing cable telephony service to any particular area to up to 25% in the sixth year and thereafter. (iii) Additional monthly subscriber fees equal to 15% of the excess, if any, of monthly average cable telephony revenues in a particular service area over $100, after the fifth year of providing cable telephony service to any particular area. Further, management believes that the opportunity for consumers to select one provider of AT&T- branded, "all-distance" wireline and wireless communication services will contribute to increased cable television penetration in Time Wamer Cable's service areas and the continuing growth in Time Warner Cable's revenues from the delivery of cable television services. This transaction is expected to close in the second half of 1999, subject to the execution of definitive agreements by the parties and customary closing conditions, including the approval of Advance/Newhouse and MediaOne and all necessary governmental and regulatory approvals. There can be no assurance that such agreements will be completed or that such approvals will be obtained. Off-Balance Sheet Assets As discussed below, TWE believes that the value of certain off-balance sheet assets should be considered, along with other factors discussed elsewhere herein, in evaluating TWE's financial condition and prospects for future resul*s of operations, including its ability to meet its capital and liquidity needs. Intangible Assets As a creator and distributor of branded information and entertainment copyrights, TWE has a significant amount of internally generated intangible assets whose value is not fully reflected in the consolidated balance sheet. Such intangible assets extend across TWE's principal business interests, but are best exemplified by its interest in Warner Bros.' and HBO's copyrighted film and television product libraries, and the creation or extension of brands. Generally accepted accounting principles do not recognize the value of such assets, except at the rime they may be acquired in a business combination accounted for by the purchase method of accounting. Because TWE normally owns the copyrights to such creative material, it continually generates revenue through the sale of such products across different media and in new and existing markets. The value of film and television-related copyrighted product and trademarks is continually realized by the licensing of films and television series to secondary markets and the licensing of trademazks, such as the Looney Tunes characters and Batman, to the retail industry and other markets. In addition, technological advances, such as the introduction of the home videocassette in the 1980's and, potentially, the current exploitation of the digital vicleo disc, have historically generated significant revenue opportunities through the repackaging and sale of such copyrighted prodncts in the new technological format. Accordingly, such intangible assets have significant off-balance sheet asset value that is not fully reflected in TWE's consolidated balance sheet. Warner Bros. Backlog Warner Bros.' backlog, representing the amount of future revenue not yet recorded from cash contracts for the licensing of theatrical and television product for pay cable, basic cable, network and syndicated television exhibition, amounted to $2.298 billion at December 31, 1998 (including amounts relating to TWE's cable television networks of $199 million and $570 million to Time Warner's cable television networks). F-86 TIME WARNER ENTERTAINMENT COMPANY, LP. MANAGEMENT'S DISCUSSION AND ANALYSIS OF RESULTS OF OPERATIONS AND FINANCIAL CONDITION —(Continued) Because backlog generally relates to contracts for the licensing of theatrical and television product which have already been produced, the recognition of revenue for such completed product is principally only dependent upon the commencement of the availability period for telecast under the terms of the related licensing agreement. Cash licensing fees are received periodically over the term of the related licensing agreements or on an accelerated basis using a$500 million securitization facility. The portion of backlog for which cash has not already been received has significant ofT balance sheet asset value as a source of future funding. The backlog excludes advertising barter contracts, which are also expected to result in the future realization of revenues and cash through the sale of advertising spots received under such contracts. Foreign Currency Risk Management Time Warner uses foreign exchange contracts primarily to hedge the risk that unremitted or future license fees owed to TWE domestic companies for the sale or anticipated sale of U.S. copyrighted products abroad may be adversely affected by changes in foreign currency exchange rates. As part of its overall strategy to manage the level of exposure to the risk of foreign currency exchange rate fluctuations, Time Warner hedges a portion of its foreign currency exposures anticipated over the ensuing twelve month period, including those related to TWE. At December 31, 1998, Time Wamer had effectively hedged approximately half of TWE's estimated foreign currency exposures that principally relate to anticipated cash flows to be remitted to the U.S. over the ensuing twelve month period. To hedge this exposure, Time Warner used foreign exchange contracts that generally have maturities of three months or less, which generally will be rolled over to provide continuing coverage throughout the year. TWE is reimbursed by or reimburses Time Warner for Time Warner contract gains and losses related to TWE's foreign currency exposure. Time Warner often closes foreign exchange contracts by purchasing an offsetting purchase contract. At December 31, 1998, Time Warner had contracts for the sale of $755 million and the purchase of $259 million of foreign currencies at fixed rates. Of Time Warner's $496 million net sale contract position, $298 million of the foreign exchange sale contracts and $101 million of the foreign exchange purchase contracts related to TWE's foreign currency exposure, compared to contracts for the sale of $105 million of foreign currencies at December 31, 1997. Based on Time Warner's outstanding foreign exchange contracts related to TWE's exposure at December 31, 1998, each 5% devaluation of the U.S. dollar as compared to the level of foreign exchange rates for currencies under contract at December 31, 1998 would result in approximately $10 million of unrealized losses on foreign exchange contracts. Conversely, a 5% appreciation of the U.S. dollaz as compared to the level of foreign exchange rates for cunencies under contract at December 31, 1998 would result in $10 million of unrealized gains on contracts. Consistent with the nature of the economic hedge provided by such foreign exchange contracts, such unrealized gains or losses would be of�'set by corresponding decreases or increases, respectively, in the dollar vaiue of future foreign currency license fee payments that would be received in cash within the ensuing twelve month period from the sale of U.S. copyrighted products abroad. Global Financial Markets During 1998, certain financial markets, mainly Brazil, Russia and a number of Asian countries, experienced significant instability. Because less than 590 of the revenues of T'WE are derived from the sale of products and services in these countries, management does not believe that the state of these financial markets poses a material risk to the operations of TWE. Euro Conversion Effective January 1, 1999, the "euro" was established as a single currency valid in more than two-thirds of the member countries of the European Union. These member countries have a three-year transitional period to physically convert their sovereign currencies to the euro. By July 1, 2002, all participating member countries must eliminate their currencies and replace their legal tender with euro-denominated bills and coins. F-87 TIME WARNER ENTERTAINMENT COMPANY, L.P. MANAGEMENT'S DISCUSSION AND ANALYSIS OF RESULTS OF OPERATIONS AND FINANCIAL CONDTTION —(Continued) Notwithstanding this transitional period, many commercial transactions are expected to become euro- denominated well before the July 2002 deadline. Accordingly, TWE continues to evaluate the short-term and long-term effects of the euro conversion on its European Operations, principally filmed entertainment. TWE believes that the most significant short-term impact of the euro conversion is the need to modify its accounting and information systems to handle an increasing volume of transactions during the transitional period in both the euro and sovereign currencies of the participating member countries. TWE has identified its accounting and information systems in need of modification and an action plan has been formulated to address the nature and timing of remediation efforts. Remediation efforts have begun and the plan is expected to be substantially completed well before the end of the transitional period. This timetable will be adjusted, if necessary, to meet the anticipated needs of TWE's vendors and customers. Based on preliminary information, costs to modify its accounting and information systems are not expected to be material. TWE believes that the most significant long-term business risk of the euro conversion may be increased pricing pressures for its products and services brought about by heightened consumer awareness of possible cross-border price differences. However, TWE believes that these business risks may be offset to some extent by lower material costs, other cost savings and marketing opportunities. Notwithstanding such risks, management does not believe that the euro conversion will have a material effect on TWE's financial position, results of operations or cash flows in future periods. Year 2000 Technology Preparedness TWE, like most. large companies, depends on many different computer systems and other chip-based devices for the continuing conduct of its business. Older computer programs, computer hardware and chip- based devices may fail to recognize dates beginning on January 1, 2000 as being valid dates, and as a result may fail to operate or may operate improperly when such dates are introduced. TWE's exposure to potential Year 2000 problems arises both in technological operations under the control of the Company and in those dependent on one or more third parties. These technological operations include information technology ("IT") systems and non-IT systems, including those with embedded technology, hardware and software. 1Vlost of TWE's potential Year 2000 exposures are dependent to some degree on one or more third parties. Failure to achieve high levels of Year 2000 compliance could have a material adverse impact on TWE and its financial statements. The Company's Year 2000 initiative is being conducted at the operational level by divisional project managers and senior technology executives overseen by senior divisional executives, with assistance internally as well as from outside professionals. The progress of each division through the different phases of remediation-inventorying, assessment, remediation planning, implementation and final testing-is actively overseen and reviewed on a regular basis by an executive oversight group. The Company has generally completed the process of identifying potential Year 2000 difficulties in its technological operations, including IT applications, IT technology and support, desktop hardware and software, non-IT systems and important third party operations, and distinguishing those that are "mission critical" from those that are not. An item is considered "mission critical" if its Year 2000-related failure would significantly impair the ability of one of the Company's major business units to (1) produce, market and distribute the products or services that generate significant revenues for that business, (2) meet its obligations to pay its employees, artists, vendors and others or (3) meet its obligations under regulatory requirements and internal accounting controls. The Company and its divisions have identified approximately 600 worldwide, "mission critical" potential exposures. Of these, as of December 31, 1998, approximately 41% have been identified by the divisions as Year 2000 compliant, approximately 41% as in the remediation implementation or final testing stages, approximately 18% as in the remediation planning stage and less than 1% as in the assessment stage. The Company currently expects that the assessment phase for these few remaining potential F-88 TIME WARNER ENTERTAINMENT COMPANY, LP. MANAGEMENT'S DISCUSSION AND ANALYSIS OF RESULTS OF OPERATIONS AND FINANCIAL CONDTTION —(Continued) exposures should be completed during the first quarter of 1999 and that remediation with respect to approximately 80% of all these identified operations will be substantially completed in all material respects by the end of the second quarter of 1999. The Company, however, could experience unexpected delays. The Company is currently planning to impose a"quiet" period at the beginning of the fourth quarter of 1999 during which any remaining remediation involving installation or modification of systems that interface with other systems will be minimized to permit the Company to conduct testing in a stable environment: As stated above, however, the Company's business is heavily dependent on third parties and these parties are themselves heavily dependent on technology. In some cases, the Company's third party dependence is on vendors of technology who are themselves worlcing towards solurions to Year 2000 problems. For example, in a situation endemic to the cable industry, much of the Company's headend equipment that controls cable set- top boxes was not Yeaz 2000 compliant as of December 31, 1998. ?he box manufacturers are working with cable industry groups and have developed solutions that the Company is installing in its headend equipment. It is currently expected that these solutions will be substantially implemented by the end of the second quarter of 1999. In other cases, the Company's third party dependence is on suppliers of products or services that are themselves computer-intensive. For example, if a television broadcaster or cable programmer encounters Year 2000 problems that impede its ability to deliver its programming, the Company will be unable to provide that programming to its cable customers. Similazly, because the Company is also a programming supplier, third- party signal delivery problems could affect its ability to deliver its programming to its customers. The Company has attempted to include in its "mission critical" inventory significant service providers, vendors, suppliers, customers and governmental entities that are believed to be critical to business,operations and is in various stages of ascertaining their state of Yeaz 2000 readiness through various means, including question- naires, interviews, on-site visits, system interface testing and industry group participation. Moreover, TWE is dependent, like all large companies, on the conrinued functioning, domestically and intemationally; of basic, heavily computerized services such as banking, telephony and power, and various distribution mechanisms ranging from the mail, railroads and trucking to high-speed data transmission. TWE is taking steps to attempt to satisfy itself that the third parties on which it is heavily refiant are Year 2000 compliant or that altemate means of ineeting its requirements are available, but cannot predict the likelihood of such compliance nor the direct or indirect costs to the Company of non-compliance by those third parties or of securing such services from altemate compliant third parties. In areas in which the Company is uncertain about the anticipated Year 2000 readiness of a significant third party, the Company is investigating available alternatives, if any. The Company currently estimates that the aggregate cost of its Year 2000 remediation program, which started in 1996, will be approximately $50 to $85 million, of which an estimated 45% to 55% has been incurred through December 31, 1998. These costs include estimates of the costs of assessment, replacement, repair and upgrade, both planned and unplanned, of certain IT and non-IT systems and their implementation and testing. The Company anticipates that its remediation program, and related expenditures, may continue into 2001 as temporary solutions to Year 2000 problems aze replaced with upgraded equipment. These expenditures have been and are expected to continue to be funded from the Company's operating cash flow and have not and are not expected to impact materially the Company's financial statements. Management believes that it has established an effecrive program to resolve all significant Year 2000 issues in its control in a timely manner. As noted above, however, the Company has not yet completed all phases of its program and is dependent on third parties whose progress is not within its control. In the event that the Company does not complete any of its currently planned additional remediation prior to the Year 2000, management believes that the Company could experience significant difficulty in producing and delivering its products and services and conducting its business in the Year 2000 as it has in the past. In addition, disruptions experienced by third parties with which the Company dces business as well as by the economy generally could also materially adversely affect the Company. The amount of potential liability and lost revenue cannot be reasonably estimated at this time. F-89 TIME WARNER ENTERTAINMENT COMPANY, LP. MANAGEMENT'S DISCUSSION AND ANALYSIS OF RESULTS OF OPERATIONS AND FINANCIAL CONDITION —(Continued) The Company has been focusing its efforts on identification and remediation of its Year 2000 exposures and has not yet developed significant, specific contingency plans in the event it does not successfully complete all phases of its Year 2000 program. The Company, however, has begun to examine its existing standard business interruption strategies to evaluate whether they would satisfactoril� meet the demands of failures arising from Year 2000-related problems. The Company intends to examine its status periodically to determine the necessity of establishing and implementing such contingency plans or additional strategies, which could involve, among other things, manual workarounds, adjusting staffing strategies and sharing resources across divisions. Caution Concerning Forward-Looking Statements The Securities and Exchange Commission encourages companies to disclose forward-looking information so that investors can better understand a company's future prospects and make informed investment decisions. This document, together with management's public commentary related thereto, contains such "forward- looking statements" within the meaning of the Private Securities Litigation Reform Act of 1995, particularly statements anticipating future growth in revenues, EBITA and cash flow. Words such as "anticipate," "esrimate," "expects," "projects," "intends," "plans," "believes" and words and terms of similar substance used in connection with any discussion of future operating or financial performance idenrify such forward- looldng statements. Those forward-looking statements are management's present expectations of future events. As with any projection or forecast, they are inherently susceptible to changes in circumstances, and TWE is under no obligation to (and expressly disclaims any such obligation to) update or alter its forward- looking statements whether as a result of such changes, new information or otherwise. TWE operates in highly competitive, consumer driven and rapidly changing media and entertainment businesses that are dependent on govemment regulation and economic, political and social conditions in the countries in which they operate, consumer demand for their products and services, technological developments and (particularly in view of technological changes) protection of their intellectual property rights. 'TWE's actual results could differ materially from management's expectations because of changes in such factors. Some of the other factors that also could cause actual results to differ from those contained in the forward- looldng statements include those identified in TWE's other filings and: For 1"WE's cable business, more aggressive than expected comperition from new technologies and other types of video programming distributors, including DBS; increases in government regulation of cable or equipment rates (or any failure to reduce rate regulation as is presently mandated by statute) or other terms of service (such as "digital must-carry" or "unbundling" requirements); increased difficulty in obtaining franchise renewals; the failure of new equipment (such as digital set-top boxes) or services (such as high-speed online services or telephony over cable or video on demand) to function properly, to appeal to enough consumers or to be available at reasonable prices and to be delivered in a timely fashion; and greater than expected increases in programming or other costs. For TWE's cable programming and television businesses, greater than expected programming or production costs; public and cable operator resistance to price increases (and the negative impact on premium programmers of increases in basic cable rates); increased regulation of distribution agree- ments; the sensitivity of advertising to economic cyclicality; and greater than expected fragmentation of consumer viewership due to an increased number of programming services or the increased popularity of altematives to television. • For TWE's film and television businesses, their ability to continue to attract and select desirable talent and scripts at manageable costs; increases in production costs generally; fragmentation of consumer leisure and entertainment time (and its possible negative effects on tlie broadcast and cable networks, F-90 TIME WARNER ENTERTAINMENT COMPANY, LP. MANAGEMENT'S DLSCUSSION AND ANALYSIS OF RESULTS OF OPERATIONS AND FINANCIAL CONDTfION —(Continued) which are significant customers of these businesses); continued popularity of inerchandising; and the uncertain impact of technological developments such as DVD and the Internet. • The ability of the Company and its key service providers, vendors, suppliers, customers and govemmental entities to replace, modify or upgrade computer systems in ways that adequately address the Year 2000 issue, including their ability to identify and correct all relevant computer codes and embedded chips, unanticipated difficulties or delays in the implementation of the Company's remediation plans and the ability of third parties to address adequately their own Year 2000 issues. In addition, TWE's overall financial strategy, including growth in operations, maintaining its financial ratios and strengthened balance sheet, could be adversely affected by increased interest rates, failure to meet earnings expectations, significant acquisitiohs or other transactions, consequences of the euro conversion and changes in TWE's plans, strategies and intentions. F-91 TIME WARNER ENTERTAINMENT COMPANY, LP. CONSOLIDATED BALANCE SHEET December 31, (millions) 1998 1997 ASSETS Current assets Cash and equivalents .............................................................................. $ 87 $ 322 Receivables, including $765 and $385 million due from Time Warner, less allowances oF $506 and $424 million ..... 2,618 1,914 lnventories...................................................................................... 1,312 I,204 Prepaidexpenses ................:................................................................ 166 ]82 Totalcurrent assets ............................................................................... 4,183 3,622 N oncurrentinventories ............................................................................ Loan receivable from Time Warner ................................................................. ]nvestments ..................................................................................... Property,plant and equipment, net .................................................................. Cable television franchises ........................................:................................ Goodwill........................................................................................ Otherassets ......:........................................... ................................... 2,327 400 886 6,041 3,773 3,854 766 Totalassets...................................................................................... $22,230 LIABILITIES AND PARTNERS' CAPITAL Current liabilities Accounts payable ................................................................................. $ 1,473 Participations and programming costs payable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . I,515 Debt due within one year .......................................................................... 6 Other current liabilities, including $370 and $184 miliion due to Time Warner .. ... ... . . . ... .. . . .. .... .. .. . 1,942 Total current liabilities . . . . . . . .. . . . . . . . . .. ... . . . ... . .. . . . . .. . .. . . . . .. .. . . .. . . . . . . . . . . . . . . . . . . . . . . . . 4,936 2,254 400 315 6,557 3,063 3,859 661 $20,73 I $ 1,123 1,176 8 1,667 3,974 Long-term debt .................................................................................. 6,578 5,990 Other ]ong-term liabilities, including $1.130 billion and $477 million due to Time Warner ....... ... .. .... ... 3,267 1,873 Minorityinterests................................................................................. 1,522 1,210 Preferred stock of subsidiary holding solely a mortgage note of its parent . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 217 233 Time Warner General Partners' Senior Capital ..... .. ..... .. ... ... ...... ... .... ........... . .. ... . . . ... 603 l,l 18 Partners' cspital Contributed capital ............................................................................... 7,341 7,537 U ndistributed partnership earnings (deficit) .......................................................... (2,234) (1,204) Totalpartners'capital ............................................................................. 5,107 6,333 Total liabilities and partners' capital . . . . . . .. . .. . . . . .. .. . . . . . . . . . . . . . . . . . . . . . . . . . .. . . . . . . . . .. . . . . . . . .. $22,230 $20,731 See accompanying notes. F-92 TIME WARNER ENTERTAINMENT COMPANY, LP. CONSOLIDATED STATEMENT OF OPERATIONS Years Ended December 31, (millions) 1998 Revenues (a) ........................................................................ $12,246 Cost ofrevenues (a)(b) ............................................................... 8,196 Selling, general and administrative (a) (b) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2,331 Operating expenses .................................................................... 10,527 Business segment operating income . ............ .. ..... .......... .... ... ... ..... . ... ... .. 1,719 Interest and other, net (a) ............................................................. (965) Minority interest ...................................................................... (264) Corporate services (a) ................................................................. (72) ]ncome beforo income taxes ............................................................ 418 lncometaxes ......................................................................... (92) Income before extraordinary item ........................................................ 326 Extraordinary loss on retirement of debt .................................................. — Netincome.......................................................................... $ 326 1997 $11,318 7,406 2,468 9,874 1,444 (345) (305) (72) 722 (85) 637 (23) $ 614 1996 $10,852 7,441 2,333 9,774 1,078 (522) (207) (69) 280 (70) 210 $ 210 (a) Includes the following income (expenses) resulting from transactions with the partners of TWE and other related Companies for the years ended December 31, 1998, 1997 and 1996, respectively: revenues-$695 million, $431 million and $198 million; cost of revenues- $(220) million, $(167) million and $(95) million; selling, gcneral and administrative-$(26) miilion, $18 million and $(38) million; interest and other, net-$6 million, $30 million and $30 miilion; and corporate services-$(72) million, $(72) million and $(69) million (Note 14). (b) Includes depreciation and amortiution expense of ..................................... $ 1,436 $ 1,370 $ 1,235 See accompanying notes. F-93 TIME WARNER ENTERTAINMENT COMPANY, LP. CONSOLIDATED STATEMENT OF CASH FLOWS Years Ended December 31, (millions) 1998 OPERATIONS Netincome.......................................................................... $ 326 Adjustments for noncash and nonoperating items: Extraordinary loss on retirement of debt . . . . . . . .. . . . . . . . .. .. . . .. . . . . .. . . . . .. . . . . . . . . . .. . . . — Depreciation and amortization .......................................................... 1,436 Equity in losses of investee companies after distributions . . . . . . . . . . .. . . .. . . . . . . . . . . . . . . . . . . .. 149 Changes in operating assets and liabilities: Receivables......................................................................... (825) Inventories......................................................................... (238) Accounts payable and other liabilities .................................................. 1,178 Other balance sheet changes .......................................................... 262 Cash provided by operations ............................................................ 2,288 INVESTING ACTIVITIES lnvestments and acquisitions ............................................................ (388) Capital expenditures ................................................................... (1,603) ]nvestment procecds ................................................................... 1,246 Cash used by investing activities ........................................................ (745) FINANCINC ACTIVITIES Borrowings........................................................................... 1,514 Debtrepayments ...................................................:.................. (1,898) Issuance of preferred stock of subsidiary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . — Collections on note receivable from MediaOne . . . . .. .. . . .. .. . .. . ... . . . . . ... . . . . . . . ... ... .. — Capital distributions ................................................................... (1,153) Other............................................................................... (241) Cash used by financing activities ........................................................ (1,778) INCREASE (DECREASE) IN CASH AND EQUIVALENTS .............................. (235) CASH AND EQUIVALENTS AT BECINNING OF PERIOD . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 322 1997 1996 $ 614 $ 210 23 — 1,370 f,235 57 38 (273) (50) (I14) (637) 393 970 (236) 146 I ,834 I ,912 (172) (146) (1,565) (1,719) 485 612 (1,252) (1,253) 3,400 ( 3,085 ) 243 (934) (100) (476) 106 216 215 (716) 169 (228) (92) (652) 7 209 CASH AND EQUIVALENTS AT END OF PERIOD ........... ...... ....... .. ...... ..... $ 87 $ 322 $ 216 See accompanying notes. F-94 TIME WARNER ENTERTAINMENT COMPANY, LP. CONSOLIDATED STATEMENT OF PARTNERSHIP CAPITAL ( millions) BALANCE AT DECEMBER 31, 1995 ... .................. Net income . . . . . . . . . . . . . . . . . . . . . .. . . . . . . . . . . . . . . . . . . . . . . increase in unrealized gains on securities . . . . . . . . . . . . . . .. . . . . Foreign currency translation adjustments . . .. . . . . . . . . . . . . . . . . Comprehensive income . .. . . .. ... . . . .. . .. . . . . . . . . . . . . . Stock option and tax-related distributions . . . . . . . . . . . . . . . . . . . . Capital contributions ..................................... Allocation of income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Collections.............................................. BALANCE AT DECEMBER 31, 1996 . .. ... ... . . . . . . ... . . . Netincome ............................................. Increase in unrealized gains on securities . . . ... . . . . . . . . . . . . . . Foreign currency translation adjustments . . . . . . . . . . . . . . . . . . . . Comprehensive income . . . .. .. .. . . . . . .. .. .. .. .. . . .. .. . Stock option, tax-related and Senior Capital distributions ...... Allocation of income . . . .. . . . . . . .. . ... . . ..... . .. . . ... . . . . . BALANCE AT DECEMBER 31, 1997 .....,,. ........... ... Netincome ............................................. lnerease in unrealized gains on securities . . ..... ... . . . .... . . . Foreign currency translation adjustments . ...... .... .... .. . .. Increase in realized and unrealized losses on derivative financial instruments ........................................... Comprehensive inoome . . . . . . . .. . . .. ... . . . ... . ... . . ... Stxk option, tax-related and Senior Capital distributions ... ... Distribution of Time Werner Telecom interests . . . . . . . . . . . . . . . Allocation of income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Other.................................................. BALANCE AT DECEMBER 31, 1998 ... ... ......: ........ See accompanying notes. Time Warner Partners' Capital General Undistributed Partners' Partnership MediaOne Total Senior Contributed Earnings Note Partners' Capital Capital (Deficit) Receivable Capital $1,426 $7,522 $ (875) $(169) $ 6,478 210 210 4 4 14 14 228 228 (199) (199) 15 117 (117) 169 1,543 (535) 110 I,118 (579) 64 $ 603 F-95 7,537 (963) 614 7 (29) 592 (723) (110) 7,537 (1,204) 326 2 (1) (6) 321 ( I,287) (191) (64) (5) $7,341 $(2,234) $ — 15 (117) l69 6,574 614 7 (29) 592 (723) (110) 6,333 326 2 ��) (6) 321 (1,287) (191) (64) (5) $ 5,107 TIME WARNER ENTERTAINMENT COMPANY, L.P. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 1. ORGANIZATION AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES Description of Business Time Warner Entertainment Company, L.P., a Delaware limited partnership ("TWE"), classifies its business interests into three fundamental areas: Cable Networks, consisting principally of interests in cable television programming; Entertainment, consisting principally of interests in filmed entertainment, television production and television broadcasting; and Cable, consisting principally of interests in cable television systems. Each of the business interests within Cable Networks, Entertainment and Cable is important to TWE's objective of increasing partner value through the creation, extension and distribution of recognizable brands and copyrights throughout the world. Such brands and copyrights include (1) HBO and Cinemax, the leading pay television services (2) the unique and extensive film, television and animation libraries of Wamer Bros. and trademarks such as the Looney Tunes characters and Batman, (3) The WB Network, a national broadcasting network launched in 1995 as an extension of the Warner Bros. brand and as an additional distribution outlet for Warner Bros.' collection of children's cartoons and television programming and (4) Time Warner Cable, currenfly the largest operator of cable television systems in the U.S. The operating results of TWE's various business interests are presented herein as an indication of financial performance (Note 12). Except for start-up losses incuned in connection with The WB Network, TWE's principal business interests generate significant operating income and cash flow from operations. The cash flow from operations generated by such business interests is considerably greater than their operating income due to.significant amounts of noncash amoRization of intangible assets recognized principally in Time Warner Companies, Inc.'s ("Time Warner") $14 billion acquisition of Warner Communications Inc. ("WCI") in 1989 and $1.3 billion acquisition of the minority interest in American Television and Communications Corporation ("ATC") in 1992, a portion of which cost was allocated to TWE upon the capitalization of the partnership. Noncash amortization of intangible assets recorded by TWE's businesses amounted to $509 million in 1998, $430 million in 1997 and $436 million in 1996. Time Warner and certain of its wholly owned subsidiaries collectively own general and limited partnership interests in TWE consisting of 74.49% of the pro rata priority capital ("Series A Capital") and residual equity capital ("Residual Capital"), and 100% of the senior priority capital ("Senior Capital") and junior priority capital ("Series B Capital"). The remaining 25.51% limited partnership interests in the Series A Capital and Residual Capital of TWE are held by a subsidiary of MediaOne Group, Inc. ("MediaOne"), formerly U S WEST, Inc., which acquired such interests in 1993 for $1.532 billion of cash and a$1.021 billion 4.4% note (the "MediaOne Note Receivable") that was fully collected during 1996. Certain of Time Warner's subsidiaries are the general partners of TWE ("Time Warner General Partners"). Basis of Presentation The consolidated fina*�cial statements of TWE reflect certain cable-related transactions as more fully described herein (Note 2). Certain reclassifications have been made to the prior years' financial statements to conform to the 1998 presentation. Basis of Consolidation and Accounting for Investments The consolidated financial statements include 100% of the assets, liabilities, revenues, expenses, income, loss and cash flows of TWE and all companies in which TWE has a controlling voting interest ("subsidiar- ies"), as if TWE and its subsidiaries were a single company. Significant intercompany accounts and transactions between the consolidated companies have been eliminated. Significant accounts and transactions between TWE and its partners and af�liates are disclosed as related party transactions (Note 14). F-96 TIME WARNER ENTERTAINMENT COMPANY, LP. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS —(Continued) Investments in companies in which TWE has significant influence, but less than a controlling voting interest, are accounted for using the equity method. Under the equity method, only TWE's investment in and amounts due to and from the equity investee are included in the consolidated balance sheet, only TWE's share of the investee's earnings is included in the consolidated operating results, and only the dividends, cash distributions, loans or other cash received from the investee, less any additional cash investments, loan repayments or other cash paid to the investee are included in the consolidated cash flows. Investments in companies in which TWE does not have a controlling interest or an ownership and voting interest so large as to exert significant influence are accounted for at market value if the investments are publicly traded and there are no resale restricrions, or at cost, if the sale of a publicly traded investment is restricted or if the investment is not publicly traded. Unrealized gains and losses on investments accounted for at market value are reported in partners' capital until the investment is sold, at which time the realized gain or loss is included in income. Dividends and other distributions of earnings from both market value and cost method investments are included in income when declared. Foreign Currency Translation The financial position and operating results of substantially all foreign operations are consolidated using the local currency as the functional currency. Local currency assets and liabilities are translated at the rates of exchange on the balance sheet date, and local currency revenues and expenses are translated at average rates of exchange during the period. Resulting translation gains or losses, which have not been material, are included in partners' capital. Use of Estimates The preparation of financial statements in conformity with generally accepted accounting principles requires management to make estimates and assumptions that affect the amounts reported in the financial statements and footnotes thereto. Actual results could differ from those estimates. Significant estimates inherent in the preparation of the accompanying consolidated financial statements include managemeni's forecast of anticipated revenues from the distribution of theatrical and television product in order to evaluate the ultimate recoverability of accounts receivables and film inventory recorded as assets in the consolidated balance sheet. Accounts receivables and sales related to the distribution of home video product in the filmed entertainment industry are subject to customers' rights to return unsold items. Management periodically reviews such estimates and it is reasonably possible that management's assessment of recoverability of accounts receivables and individual films and television product may change based on actual results and other factors. Revenues and Costs Cable and Cable Networks A significant portion of cable system and cable programming revenues are derived from subscriber fees. Subscriber fees are recorded as revenue in the period the service is provided. The costs of rights to exhibit feature films and other programming on pay cable services during one or more availability periods ("programming costs" ) generally are recorded when the programming is initially available for exhibition, and are allocated to the appropriate availability periods and amortized as the programming is exhibited. Filmed Entenainment Feature films are produced or acquired for initial exhibition in theaters followed by distribution in the home video, pay cable, basic cable, broadcast network and syndicated television markets. Generally, distribution to the theatrical, home video and pay cable markets (the primary markets) is principally F-97 TIME WARNER ENTERTAINMENT COMPANY, LP. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS —(Continued) completed within eighteen months of inirial release. Thereafter, feature films are distributed to the basic cable, broadcast network and syndicated television markets (the secondary markets). Theatrical revenues are recognized as the films are exhibited. Home video revenues, less a provision for returns, are recognized when the home videos are sold. Revenues from the distribution of theatrical product to cable, broadcast network and syndicated television markets are recognized when the films are available to telecast. Television films and series are initially produced for the networks or first-run television syndicarion (the primary markets) and may be subsequently licensed to foreign or domestic cable and syndicated television markets (the secondary markets). Revenues from the distribution of television product are recognized when the films or series are available to telecast, except for barter agreements where the recognition of revenue is deferred until the related advertisements are exhibited. License agreements for the telecast of theatrical and television product in the cable, broadcast network and syndicated television markets are routinely entered into well in advance of their available date for telecast, which is generally determined by the telecast privileges granted under previous license agreements. Accord- ingly, there are significant contractual rights to receive cash and barter under these licensing agreements. For cash contracts, the related revenues will not be recognized until such product is available for telecast under the contractual terms of the related license agreement. For barter contracts, the related revenues will not be recognized unril the product is available for telecast and the advertising spots received- under such contracts are either used or sold to third parties. All of these contractual rights for which revenue is not yet recognizable is referred to as "backlog." Excluding advertising barter contracts, Warner Bros.' backlog amounted to $2.298 billion at December 31, 1998 (including amounts relating to the licensing of film product to TWE's cable television networks of $199 million and $570 million to Time Warner's cable television networks). Inventories of theatrical and television product are stated at the lower of amortized cost or net realizable value. Cost principally consists of direct production costs and production overhead. A portion of the cost to acquire WCI in 1989 was allocated to its theatrical and television product, including an allocation to product that had been exhibited at least once in all markets ("Library"). Library product is amortized on a straight- line basis over twenty years. Individual films and series are amortized, and the related participarions and residuals are accrued, based on the proportion that current revenues from the film or series bear to an estimate of total revenues anticipated from all markets. These estimates are revised periodically and losses, if any, are provided in full. Current film inventories generally include the unamortized cost of completed feature films allocated to the primary markets, television films and series in production pursuant to a contract of sale, film rights acquired for the home video market and advances pursuant to agreements to distribute third-party films in the primary markets. Noncurrent film inventories generally include the unamortized cost of completed theatrical and television films allocated to the secondary markets, theatrical films in production and the Library. Proposed Changes to Film Accounting Standards In October 1998, the Accounting Standards Executive Committee of the American Institute of Certified Public Accountants ("AcSEC") issued an exposure draft of a proposed Statement of Position, "Accounting by Producers and Distributors of Films" (the "SOP"). The proposed rules would establish new accounting standards for producers and distributors of films. Among its many provisions, the SOP would require revenue for the licensing of film and television product to be recognized generally over the term of the related agreement. This would represent a significant change to existing industry practice, which generally requires such licensing revenue to be recognized when the product is first available for telecast. This is because, after that date, licensors have no further significant obligations under the terms of the related licensing agreements. While the SOP's proposals in many other areas (i.e., advertising and film cost amortization) generally are consistent with TWE's accounting policies, this is not the case with the proposed changes in revenue recognition for licensed product. Adopting the proposed accounting standards for licensed product would F-98 TIME WARNER ENTERTAINMENT COMPANY, LP. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS —(Continued) result in a significant one-time, noncash charge to earnings upon adoption that would be reflected as a cumulative ef%ct of a change in accounting principle. This one-time, noncash charge would be reversed in future periods as an increase to operating income when TWE re-recognizes the revenues associated with the licensing of its film and television product over the periods of the related licensing agreements. The SOP proposes an eSective date of January 1, 2000 for calendar year-end companies, with earlier application encouraged. The provisions of the SOP are still being deliberated by AcSEC and could change significantly prior to the issuance of a final standard. Advertising In accordance with the Financial Accounring Standards Board ("FASB") Statement No. 53, "Financial Reporting by Producers and Distributors of Motion Picture Films," advertising costs for theatrical and television product are capitalized and amortized over the related revenue streams in each market that such costs are intended to benefit, which generally dces not exceed three months. Other advertising costs are expensed upon the first exhibition of the advertisement. Advertising expense, excluding theatrical and television product, amounted to $284 million in 1998, $288 million in 1997 and $332 million in 1996. Cash and Equivalents Cash equivalents consist of commercial paper and other investments that are readily convertible into cash and have original maturities of three months or less. Financial Instruments Effective July 1, 1998, TWE adopted FASB Statement No. 133, "Accounting for Derivative Instruments and Hedging Activities" ("FAS 133"). FAS 133 requires that all derivative financial instruments, such as foreign exchange contracts, be recognized in the financial statements and measured at fair value regardless of the purpose or intent for holding them. Changes in the fair value of derivative financial instruments are either recognized periodically in income or shareholders' equity (as a component of comprehensive income), depending on whether the derivative is being used to hedge changes in fair value or cash flows. The adoption of FAS 133 did not have a material effect on TWE's financial statements. The carrying value of TWE's financial instruments approximates fair value, except for differences with respect to long-term, fixed-rate debt (Note 5) and certain differences relating to cost method investments and other financial instruments that are not significant. The fair value of financial instruments is generally determined by reference to market values resulting from trading on a national securities exchange or in an over-the-counter market. In cases where quoted market prices are not available, fair value is based using present value or other valuation techniques. Property, Plant and Equipment Property, plant and equipment aze stated at cost. Additions to cable property, plant and equipment generally include material, labor, overhead and interest. Depreciation is provided generally on the straight-line F-99 TIME WARNER ENTERTAINMENT COMPANY, LP. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS —(Continued) method over useful lives ranging up to thirty years for buildings and improvements and up to sixteen years for furniture, fixtures, cable television and other equipment. Property, plant and equipment consists of: Land and buildings ............................................... Cable television equipment . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Furniture, fixtures and other equipment . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Less accumulated depreciation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Total........................................................... Intangible Assets December 31, 1998 1997 (millions) $ 797 $ 804 6,612 7,423 2,313 2,310 9,722 10,537 3,681) (3,980) $ 6,041 $ 6,557 As a creator and distributor of branded information and entertainment copyrights, TWE has a significant and growing number of intangible assets, including goodwill, cable television franchises, film and television libraries and other copyrighted products and trademarks. In accordance with generally accepted accounting principles, TWE does not recognize the fair value of internally generated intangible assets. Costs incurred to create and produce copyrighted product, such as feature. films and television series, are generally either expensed as incurred, or capitalized as tangible assets, as in the case of cash advances and inventoriable product costs. However, accounting recognition is not given to any increasing asset value that may be associated with the collection of the underlying copyrighted material. Additionally, costs incurred to create or extend brands, such as the start-up of The WB Network and Internet sites, generally result in losses over an extended development period and are recognized as a reduction of income as incurred, while any correspond- ing brand value created is not recognized as an intangible asset in the consolidated balance shee.t. Un the other hand, intangible assets acquired in business combinations accounted for by the p.urchase method of accounting are capitalized and amortized over their expected useful life as a noncash charge against future results of operations. Accordingly, the intangible assets reported in the consolidated balance sheet do not reflect the fair value of TWE's internally generated intangible assets, but rather are limited to intangible assets resulting from certain acquisitions in which the cost of the acquired companies exceeded the fair value of their tangible assets at the time of acquisition. TWE amortizes goodwill over periods up to forty years using the straight-line method. Cable television franchises, film and television libraries and other intangible assets are amortized over periods up to twenty years using the straight-line method. Amortization of intangible assets amounted to $509 million in 1998, $430 million in 1997 and $436 million in 1996. Accumulated amortization of intangible assets at December 31, 1998 and 1997 amounted to $3.505 billion and $3.020 billion, respectively. TWE periodically reviews the carrying value of acquired intangible assets for each acquired entity to determine whether an impairment may exist. TWE considers relevant cash flow and profitability information, including estimated future operaring results, trends and other available information, in assessing whether the carrying value of intangible assets can be recovered. If it is determined that the carrying value of intangible assets will not be recovered from the undiscounted future cash flows of the acquired business, the carrying value of such intangible assets would be considered impaired and reduced by a charge to operations in the amount of the impairment. An impairment charge is measured as any deficiency in the amount of estimated undiscounted future cash flows of the acquired business available to recover the carrying value related to the intangible assets. F-100 TIME WARNER ENTERTAINMENT COMPANY, LP. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS —(Continued) Income Taxes As a Delaware limited partnership, TWE is not subject to U.S. federal and state income taxation. However, certain of TWE's operations are conducted by subsidiary corporations that are subject to domestic or foreign taxation. Income taxes are provided on the income of such corporations using the liability method prescribed by FASB Statement No. 109, "Accounting for Income Taxes." Comprehensive Income Effective January 1, 1997, TWE adopted FASB Statement No. 130, "Reporting Comprehensive Income" ("FAS 130"). The new rules established standards for the reporting of comprehensive income and its components in financial statements. Comprehensive income consists of net income and other gains and losses affecting partners' capital that, under generally accepted accounting principles, are excluded from net income. For 1"WE, such items consist primarily of unrealized gains and losses on marketable equity investments and foreign currency translation gains and losses. The adoption of FAS 130 did not have a material effect on TWE's primary financial statements, but did affect the presentation of the accompanying consolidated statement of partnership capital. The following summary sets forth the components of other comprehensive income (loss) accumulated in partners' capital: Accumulated Foreign Derivative Other Unrealized Curtency Financial Comprehensive Gains on Translation Instrument income Securities Losses Losses (Loss) (millions) Balance at December 31, 1997 . . . . . . . . . . $7 1998 activity .......................... 2 Balance at December 31, 1998 . . . . . . . . . . $9 Segment Information $(42) $— $(35) �1) (6) (5) �43 � $�� On December 31, 1997, TWE adopted FASB Statement No. 131, "Disclosures about Segments of an Enterprise and Related Information" ("FAS 131"). The new rules established revised standards for public companies relating to the reporting of financial and descriptive information about their operating segments in financial statements. The adoption of FAS 131 did not have a material effect on TWE's primary financial statements, but did affect the disclosure of segment information contained elsewhere herein (Note 12). 2. ACQUISITIONS AND DISPOSITIONS Cable Transactions In addition to continuing to use cable operaring cash flow to finance the level of capital spending necessary to upgrade the technological capability of cable television systems and develop new services, Time Warner, TWE and the TWE-Advance/Newhouse Partnership ("TWE-A/N") completed a series of transactions in 1998. These transactions related to the cable television business and related ancillary businesses that either reduced existing debt and/or T'WE's shaze of future funding requirements for such businesses. These transactions are discussed more fully below. TCI Cable Transactions During 1998, Time Warner, TWE, TWE-A/N and TCI Communications, Inc. ("TCI"), a subsidiary of Tele-Communications, Inc., consummated or agreed to complete a number of cable-related transactions. F-101 TIME WARNER ENTERTAINMENT COMPANY, LP. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS —(Continued) These transactions consisted of (i) the formation in December 1998 of a cable television joint venture in Texas (the "Texas Cable Joint Venture") that is managed by Time Wamer Cable, a division of TWE, and owns cable television systems serving an aggregate 1.1 million subscribers, subject to approximately $1.3 billion of debt, (ii) the expansion in August 1998 of an existing joint venture in Kansas City, which is managed by Time Warner Cable, through the contribution by TCI of a contiguous cable television system serving approximately 95,000 subscribers, subject to approximately $200 million of debt and (iii) the agreement to exchange in 1999 various cable television systems serving approximately 575,000 subscribers for other cable television systems of comparable size in an effort to enhance each company's geographic clusters of cable television properties (the "TCI Cable Trades"). The Texas and Kansas City joint ventures are being accounted for under the equity method of accounting. As a result of the Texas transaction, the combined debt of TWE and TWE-A/N was reduced by approximately $650 million. Also, as a result of the Texas and Kansas City transactions, TWE benefited from the geographic clustering of cable television systems and the number of subscribers under its management was increased by approximately 660,000 subscribers, thereby making Time Warner Cable the largest cable television operator in the U.S. The TCI Cable Trades are expected to close periodically throughout 1999 and are subject to customary closing condirions, including all necessary governmental and regulatory approvals. There can be no assurance that such approvals will be obtained. Time Warner Telecom Reorganization In July 1998, in an effort to combine their Time Warner Telecom operations into a single entity that is intended to be self-financing, Time Warner, TWE and TWE-A/N completed a reorganization of their Time Warner Telecom operations (the "Time Warner Telecom Reorganization"), whereby (i) those operations conducted by Time Warner, TWE and TWE-A/N were each contributed to a new holding company named Time Warner T'elecom LLC ("Time Warner Telecom"), and then (ii) 1'WE's and TWE-A/N's interests in Time Warner Telecom were distributed to their partners, Time Wamer, MediaOne and the Advance/ Newhouse Partnership ("Advance/Newhouse"}, a limited partner in TWE-A/N. Time Warner Telecom is a comperitive local exchange carrier (CLEC) in selected metropolitan areas across the United States where it offers a wide range of telephony services to business customers. As a result of the Time Warner Telecom Reorganization, Time Warner, MediaOne and Advance/Newhouse own interests in Time Warner Telecom of 61.98%, 18.85% and 19.17%, respectively. TWE and TWE-A/N do not have continuing equity interests in these Time Warner Telecom operations. TWE and TWE-A/N recorded the distribution of their Time Warner Telecom operations to their respective partners based on the $242 million historical cost of the net assets, of which $191 million was recorded as a reduction in partners' capital and $51 million was recorded as a reduction in minority interest in TWE's consolidated balance sheet. Road Runner Joint Venture In June 1998, Time Warner, TWE, TWE-A/N, MediaOne, Microsoft Corp. ("MicrosofY') and Compaq Computcr Corp. ("Compaq") formed a joint venture to operate and expand Time Wamer Cable's and MediaOne's existing high-speed online businesses (the "Road Runner Joint Venture"). In exchange for contributing these operations, Time Warner received a common equity interest in the Road Runner Joint Venture of 10.7%, TWE received a 25% interest, TWE-A/N received a 32.9% interest and MediaOne received a 31.4% interest. In exchange for Microsoft and Compaq contributing $425 million of cash to the Road Runner Joint Venture, Microsoft and Compaq each received a preferred equity interest therein that is convertible into a 10% common equity interest. Accordingly, on a fully diluted basis, the Road Runner Joint Venture is owned 8.6% by Time Warner, 20% by TWE, 26.3% by TWE-A/N, 25.1% by MediaOne, 10% by Microsoft and 10% by Compaq. Each of Time Warner's, TWE's and TWE-A/N's interest in the Road Runner Joint Venture is being accounted for under the equity method of accounting. F-102 TIME WARNER ENTERTAINMENT COMPANY, LP. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS —(Continued) The aggregate $425 million of capital contributed by Microsoft and Compaq is being used by the Road Runner Joint Venture to continue to expand the roll out of high-speed online services. Time Warner Cable has entered into an affiliation agreement with the Road Runner Joint Venture, pursuant to which Time Warner Cable provides Road Runner's high-speed online services to customers in its cable franchise areas through its technologically advanced, high-capacity cable architecture. In exchange, Time Warner Cable initially retains 70% of the subscription revenues and 303'0 of the national advertising and transactional revenues generated from the delivery of these on-line services to its cable subscribers. Time Warner Cable's share of these subscription revenues will change periodically to 75% by 2006. Primestar In April 1998, TWE and Advance/Newhouse transferred the direct broadcast satellite operations conducted by TWE and TWE-A/N (the "DBS Operarions") and the 31% partnership interest in Primestar Partners, . L.P. held by TWE-A/N ("Primestaz Partners" and collectively, the "Primestar Assets") to Primestar, Inc. ("Primestar"), a separate holding company. As a result of that transfer and similar transfers by the other previously existing partners of Primestar Partners, Primestar Partners became an indirect wholly owned subsidiary of Primestar. In exchange for contributing its interests in the Primestar Assets, TWE received approximately 48 million shazes of Primestar common stock (representing an appro�cimate 24% equity interest) and realized approximately $240 million of debt reduction. In partial consideration for contributing its indirect interest in certain . of the Primestar Assets, Advance/Newhouse received an approximate 6% equity interest in Primestar. As a result of this transaction, effective as of April 1, 1998, TWE deconsolidated the DBS Operations and the 24°7o equity interest in Primestar received in the transaction is being accounted for under the equiry method of accounting. This transaction is referred to as the "Primestar Roll-up Transacrion." . In connection with the Primestar Roll-.up Transaction, Primestar and Primestar Partners own and operate the medium-power d'uect broadcast satellite business, portions of which were formerly owned by TCI Satellite Entertainment, Inc. ("TSAT') and the other previously existing partners of Primestar Partners. Certain high- power system assets, including two high-power satellites, continue to be owned by Tempo Satellite, Inc. ("Tempo"), a wholly owned subsidiary of TSAT. However, Primestar Partners has an option to lease or purchase the entire capacity of the high-power system from Tempo. In addition, Primestar has an option to purchase the stock or assets of Tempo from TSAT. In a related transaction, Primestar PartnBrs also entered into an agreement in June 1997 with The News Corporation Limited ("News Corp."), MCI WorldCom, Inc. ("MCI") and American Sky Broadcasting LLC ("ASkyB"), pursuant to which Primestar would acquire certain assets relating to the high-power, direct broadcast satellite business of ASkyB (the "Primestar ASkyB Transaction"). In May 1998, the U.S. Department of Justice brought a civil action against Primestar, each of its cable owners, including TWE, and News Corp. and MCI, to enjoin on anritrust grounds the Primestar ASkyB Transaction. Although the parties had discussions with the U.S. Department of Justice in an attempt to restructure the transaction, no resolution was reached and the parties terminated their agreement in October 1998. In the fourth quarter of 1998, TWE recorded a charge of approximately $210 million principally to reduce the carrying value of its interest in Primestar. This charge reflected a significant decline in the fair value of Primestar during the quarter and has been included in interest and other, net, in TWE's 1998 consolidated statement of operations. In addition, Primestar, Primestar Partners and the stockholders of Primestar have entered into an agreement to sell the medium-power direct broadcast satellite business and assets to DirecTV, a competitor of Primestar owned by Hughes Electronics Corp. Also, Primestar, Primestar Partners, the stockholders of Primestar and Tempo entered into a second agreement with DirecTV, pursuant to which DirecTV will purchase the high-power satellites from Tempo, and Primestar and Primestar Partners will relinquish their F-103 TIME WARNER ENTERTAINMENT COMPANY, L.P. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS —(Continued) respective rights to acquire or use such high-power satellites. The price to be paid by DirecTV pursuant to these agreements confirmed the decline in vaiue of TWE's interest in Primestar. The ultimate disposition of the medium-power assets of Primestar is subject to Primestar bondholder and regulatory approvals, and the disposition of certain of the high-power satellite rights is also subject to regulatory approvals. Accordingly, there can be no assurance that such approvals will be obtained and that these transactions will be consummated. TWE-A/N Transfers As of December 31, 1998, TWE-A/N owns cable television systems (or interests therein) serving approximately 6.3 million subscribers, of which 5.2 million subscribers were served by consolidated, wholly owned cable television systems and 1.1 million subscribers were served by unconsolidated, partially owned cable television systems. TWE-A/N had approximately $1.2 billion of debt at December 31, 1998. TWE-A/N is owned approximately 64.8% by TWE, the managing partner, 33.3% by Advance/ Newhouse and 1.9% indirectly by Time Warner. TWE consolidates the partnership, and the partnership interests owned by Advance/Newhouse and Time Warner are reflected in TWE's consolidated financial statements as minority interest. In accordance with the partnership agreement, Advance/Newhouse can require TWE to purchase its equity interest for fair mazket value at specified intervals following the death of both of its principal shareholders. In addition, TVVE or Advance/Newhouse can initiate a restructuring of the partnership, in which Advance/Newhouse would withdraw from the partnership and receive one-third of the partnership's net assets. In early 1998, Time Wamer (through a wholly owned subsidiary) contributed cable television systems (or interests therein) serving approximately 650,000 subscribers to TWE-A/N, subject to approximately $1 billion of debt, in exchange for common and preferred partnership interests in TWE-A/N, and completed certain related transactions (collectively, the "TWE-A/N Transfers"). The cable television systems trans- fened to TWE-A/N were formerly owned by TWI Cable Inc. ("TWI Cable"), a wholly owned subsidiary of Time Warner, and Paragon Communications ("Paragon"), a partnership formerly owning cable television systems serving approximately 1 million subscribers that was wholly owned by subsidiaries of Time Warner, with 50% beneficially owned in the aggregate by TWE and TWE-A/N. The debt assumed by TWE-A/N has been guaranteed by TWI Cable and certain of its subsidiaries, including Paragon. As part of the TWE-A/N Transfers, TWE and TWE-A/N exchanged substantially all of their respective beneficial interests in Paragon for an equivalent share of Paragon's cable television systems (or interests therein) serving approximately 500,000 subscribers, resulting in wholly owned subsidiaries of Time Warner owning 100% of the restructured Paragon entity, with less than 1% beneficially held for TWE. Accordingly, effective as of January 1, 1998, Time Warner has consolidated Paragon. Because this transaction represented an exchange of TWE's and TWE-A/N's beneficial interests in Paragon for an equivalent amount of its cable television systems, it did not have a significant economic impact on Time Warner, TWE or TWE-A/N The TWE-A/N Transfers were accounted for effective as of January 1, 1998 and TWE has continued to consolidate TWE-A/N. On a pro forma basis, giving effect to the TWE-A/N Transfers as if they had occurred at the beginning of 1997, TWE would have reported for the year ended December 31, 1997, respectively, revenues of $11.379 billion, depreciation expense of $947 million, operating income before noncash amortization of intangible assets of $1.989 billion, operating income of $1.496 billion, and net income of $607 million. Sale or Exchange of Cable Television Systems In 1998 and 1997, in an effort to enhance its geographic clustering of cable television properties, TWE sold or exchanged various cable television systems. As a result of these transactions, TWE recognized net, F-104 TIME WARNER ENTERTAINMENT COMPANY, LP. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS —(Continued) pretax gains of approximately $90 million and $200 million in 1998 and 1997, respectively, which have been included in operating income in the accompanying consolidated statement of operations. Six Flags In April 1998, TWE sold its remaining 49°6 interest in Six Flags Entertainment Corporation ("Six Flags") to Premier Parks Inc. ("Premier"), a regional theme pazk operator, for approximately $475 million of cash. TWE used the net, after-tax proceeds from this transaction to reduce debt by approximately $300 million. As part of the transaction, TWE will continue to license its animated cartoon and comic book characters to Six Flags's theme parks and will similarly license such rights to Premier's theme parks in the United States and Canada under a long-term agreement covering an aggregate of twenty-five existing and all future locations. A substantial portion of the gain on this transaction has been deferred by TWE, principally as a result of uncertainties surrounding realization that relate to ongoing litigation and TWE's continuing guarantees of certain significant long-term obligations associated with the Six Flags Over Texas and Six Flags Over Georgia theme parks. 3. INVENTORIES TWE's inventories consist of: Film costs: Released, less amortization . . . . . . . . . . . . . . . . . Completed and not released . . . . . . . . . . . . . . . . In process and other ....................... Library, less amortization . . . . . . . . . . . . . . . . . . . Programming costs, less amorazation . . . . . . . . . . . Merchandise ............................... December 31, 1998 1997 Current Noncurrent Current Noncurcent (millions) $ 614 $ 744 179 76 23 572 — 560 426 375 70 — Total ...................................... $1,312 $2,327 $ 545 $ 658 170 50 27 595 — 612 382 339 80 — $1,204 $2,254 Excluding the Library, the total cost incurred in the production of theatrical and television product (including direct production costs, production overhead and certain exploitation costs, such as film prints and home videocassettes) amounted to $2.665 billion in 1998, $2360 billion in 1997 and $2.543 billion in 1996; and the total cost amortized amounted to $2.502 billion, $2.329 billion and $].998 billion, respectively. Excluding the Library, the unamortized cost of completed films at December 31, 1998 amounted to $1.613 billion, approximately 90°l0 of which is expected to be amortized within three years after release. 4. INVESTMENTS TWE's investments consist of: Equity method investments ............................................... Cost and fair-value method investments . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Total............................................................... F-105 December 31, 1998 199'7 (millions) $574 $238 312 77 $886 $315 TIME WARNER ENTERTAINMENT COMPANY, L.P. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS —(Continued) In the first quarter of 1997, TWE sold its 58% interest in E! Entertainment Television, Inc. ("E! Entertainment"). A pretax gain of approximately $250 million relating to this sale has been included in the accompanying consolidated statement of operations. At December 31, 1998, companies accounted for using the equity method included: Comedy Partners, L.P. (50% owned), certain cable system joint ventures (generally 50% owned), the Road Runner Joint Venture (57.9% owned, excluding Time Warner's direct 10.7% interest), Primestar (24% owned), Six Flags (49% owned in 1997 and 1996), certain international cable and programming joint ventures (25% to 50% owned) and Courtroom Television Network (50% owned). A summary of combined financial information as reported by the equity investees of TWE is set forth below: Revenues .............................................. Depreciation and amortization ............................... Operating income (loss) ............................. Netloss................................................. Current assets ............................................ Total assets .............................................. Current liabilities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Long-term debt ........................................... Total liabilities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Total shareholders' equity or partners' capital . . . . . . . . . . . . . . . . . . 5. LONG-TERNi DEBT Bank credit agreement borrowings . . . . . . . Commercial paper . . . . . . . . . . . . . . . . . . . . Fixed-rate senior notes and debentures ... Years Ended December 31, 1998 1997 1996 (millions) $2,329 $2,207 $1,823 (706) (235) (197) (265) 118 62 (352) (82) (138) 665 412 624 5,228 3,046 3,193 628 993 407 2,917 1,625 2,197 3,699 2,734 2,829 1,529 312 364 Weighted-Average Interest Rate at December 31, 1998 Maturities 6.0% 2002 5.4% 1999 8.6% 2002-2033 Total ....................... . Bank Credit Agreement December 31, 1998 1997 (millions) $2,711 $1,970 62 210 3,805 3,810 $6,578 $5,990 In November 1997, TWE and TWE-A1N, together with Time Warner Inc. and certain of its consolidated subsidiaries, entered into a five-year revolving credit facility (the "1997 Credit Agreement") and terminated their previously existing bank credit facility (the "Old Credit AgreemenY'). This enabled TWE to reduce its aggregate borrowing availability from $8.3 billion to $7.5 billion, lower interest rates and refinance approximately $2.1 billion of its outstanding bonowings under the Old Credit Agreement. In connection therewith, TWE recognized an extraordinary loss of $23 million in 1997. The 1997 Credit Agreement permits borrowings in an aggregate amount of up to $7.5 billion, with no scheduled reduction in credit availability prior to maturity in November 2002. The borrowers under the 1997 Credit Agreement are TWE, TWE-A/N, Time Warner Inc., TW Companies, TBS and TWI Cable. Bonowings under the 1997 Credit Agreement are limited to (i) $7.5 billion in the case of TWE, (ii) $2 billion in the case of TWE-A/N and (iii) $6 billion in the aggregate for Time Warner Inc., TW Companies, TBS and TWI Cable, subject in each case to an aggregate borrowing limit of $7.5 billion and certain other F-106 TIME WARNER ENTERTAINMENT COMPANY, LP. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS —(Continueii) limitations and adjustments. Such borrowings bear interest at specific rates for each of the borrowers (generally equal to LIBOR plus a margin initially equal to 40 basis points for TWE and 35 basis points for TWE-A/N) and each borrower is required to pay a commitment fee on the unused portion of its commitment (initially equal to .15% per annum for TWE and .125% per annum for TWE-A/N), which margin and fee vary based on the credit rating or financiai leverage of the applicable borrower. Borrowings may be used for general business purposes and unused credit is available to support commercial paper borrowings. The 1997 Credit Agreement contains certain covenants generally for each borrower relating to, among other things, additional indebtedness; liens on assets; cash flow coverage and leverage ratios; and dividends, distributions and other restricted cash payments or transfers of assets from the borrowers to their respective shareholders, partners or affiliates. Debt Guarantees Each Time Warner General Partner has guaranteed a pro rata portion of approximately $5.5 billion of TWE's debt and accrued interest at December 31, 1998, based on the relative fair value of the net assets each Time Warner General Partner (or its predecessor) contributed to TWE (the "Time Warner General Partner Guarantees"). Such indebtedness is recourse to each Time Warner General Partner only to the extent of its guarantee. The indenture pursuant to which TWE's notes and debentures have been issued (the "Indenture") requires the majority consent of the holders of the notes and debentures to terminate the Time Warner General Partner Guarantees. There are generally no restrictions on the ability of the Time Warner General Partner guarantors to transfer material assets, other than TWE assets, to parties that are not guarantors. In addition, in connection with the TWE-A/N Transfers (Note 2), approximately $1.2 billion of TWE-A/N's debt and accrued interest at December 31, 1998 has been guaranteed by TWI Cable and certain of its subsidiaries. Interest Expense and Maturities Interest expense was $566 million in 1998, $490 million in 1997 and $475 million in 1996. The weighted average interest rate on TWE's total debt was 7.5'�o and 7.83'o at December 31, 1998 and 1997, respectively. Annual repayments of long-term debt for the five years subsequent to December 31, 1998 consist only of $3.373 billion due in 2002. This includes all borrowings under the 1997 Credit Agreement, as well as any commercial paper borrowings supported thereby. TWE has the intent and ability under the 1997 Credit Agreement to conrinue to refinance its commercial paper borrowings on a long-term basis. Fair Value of Debt Based on the level of interest rates prevailing at December 31, 1998 and 1997, the fair value of TWE's fixed-rate debt exceeded its cazrying value by $764 million and $532 million, respectively. Unrealized gains or losses on debt do not result in the realization or expenditure of cash and generally are not recognized for financial reporting purposes unless the debt is retired prior to its maturity. 6. INCOME TAXES Domesric and foreign pretax income (loss) are as follows: Yesrs Eaded December 31, 1998 1997 1996 (millions) Domestic ..................................................... $438 $654 $263 Foreign ...................................................... �) 68 17 Total........................................................ $418 $722 $280 F-107 TIME WARNER ENTERTAINMENT COMPANY, L.P. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS —(Continued) As a partnership, TWE is not subject to U.S. federal, state or local income taxation. However, certain of TWE's operations are conducted by subsidiary corporations that are subject to domestic or foreign taxation. Income taxes (benefits) of TWE and subsidiary corporations are as set forth below: Federal: Current.................................................... Deferred................................................... Foreign: Years Ended December 31, 1998 1997 1996 (miilions) $ 6 $ 2 $ 4 (7) (10) (3) Current�'� .................................................. 106 69 86 Deferred................................................ (15) 22 (21) State and local: Current.................................................... 4 4 5 Deferred................................................... �) �) �1) Totalincome taxes ............................................. $ 92 $ 85 $ 70 ( I) Includes foreign withholding taxes of $62 milfion in 1998, $58 miUion in 1997 and $54 miUion in 1996. The financial statement basis of TWE's assets exceeds the corresponding tax basis by $7.5 billion at December 31, 1998, principally as a result of differences in accounting for depreciable and amortizable assets for financial statement and income tax purposes. 7. PREFERRED STOCK OF SUBSIDIARY In February 1997, a newly formed, substantially owned subsidiary of TWE (the "REIT') issued 250,000 shares of preferred stock ("REIT Prefeaed Stock"). The REIT is intended to qualify as a real estate investment trust under the Internal Revenue Code of 1986, as amended. TWE used the aggregate net proceeds from the transaction of $243 million to reduce its bank debt. The sole asset of the REIT is a$432 million mortgage note payable by TWE, which has been secured by certain real estate owned by TWE or its affiliates. Each share of REIT Preferred Stock is entitled to a liquidation preference of $1,000 and enritles the holder thereof to receive cumulative cash dividends, payable quarterly, at the rate of 14.253% per annum through December 30, 2006 and 1% per annum thereafter, which results in an effective dividend yield of 8.48�'0. Shares of REIT Preferred Stock are redeemable currently because the REIT has received a legal opinion stating ti►at certain proposed changes to the tax regulations have substantially increased the likelihood that the dividends paid by the REIT or interest paid under the mortgage note will not be fully deductible for federal income tax purposes. TWE has the right to liquidate or dissolve the REIT at any time after December 30, 2006 or, at any time prior thereto, upon the approval of the holders of at least two-thirds of the outstanding shares of REIT Preferred Stock. 8. TWE PARTNERS' CAPITAL Partnership Capital and Allocation of Income Each partner's interest in TWE generally consists of the undistributed priority capital and residual equity amounts that were initially assigned to that partner or its predecessor based on the estimated fair value of the net assets each contributed to the partnership ("Undistributed Contributed Capital"), plus, with respect to the priority capital interests only, any undistributed priority capital return. The priority capital return consists of net partnership income allocated to date in accordance with the provisions of the TWE partnership agreement F-108 TIME WARNER ENTERTAINMENT COMPANY, LP. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS —(Continued) and the right to be allocated additional partnership income which, together, provides for the various priority capital rates of return as specified in the table below. The sum of Undistributed Contributed Capital and the undistributed priority capital return is referred to herein as "Cumulative Priority Capital." Cumulative Priority Capital is not necessarily indicative of the fair value of the underlying priority capital interests principally due to above-market rates of return on certain priority capital interests as compared to securities of comparabie credit risk and maturity, such as the 13.259�o rate of return on the Series B Capital interest owned by the Time Wamer General Partners. Furthermore, the ultimate realization of Cumulative Priority Capital could be affected by the fair value of TWE, which is subject to fluctuation. A summary of the priority of UndisVibuted Contributed Capital, ownership of Undistributed Contributed Capital and Cumulative Priority Capital at December 31, 1998 and priority capital rates of return thereon is set forth below: Prioriry of Undistributed Contributed Capital Senior Capital . . . . . . . . . . . . . . Series A Capital . . . . . . . . . . . . Series B Capital . . . . . . . . . . . . Residual Capital . . . . . . . . . . . . Priority Uadistribnted Camulstire Capital Cootributed Priority Rates of Capital(a) Cspitsl Returo(b) (billioas) $0.5 5.6 2.9�d� 3.3�a� 0.6 8.00% 12.8 13.00�o 6.8 13.25�'0 3.3�`� —�� Time Limited Partners Warner Geoeral Time Partners Warne� MediaOne (ownership %) 100.00% — 63.27% 11.22% 100.00% — 63.27% 11.22% 25.51% 25.51% (a) Exciudes partnership income or loss allocated thereto. (b) To the extent income allocations are concurrently distributed, the priority capital rates of return on the Series A Capital and Series B Capital are 11% and 11.25%, respectively. (c) Residual Capital is not entitled to stated priority rates of rctum and, as such, its Cumulative Priority Capital is equal to its Undistributed Contributed Capital. However, in the case of certain evenu such u the liquidation or dissolution of 7'WE, Residual Capital is entitled to eny cxcess of the then fair value of the net assets of TWE over the aggregate amount of Cumulative Priority Capital and special tax allocations. (d) 7'he Undistributed Contributed Capital rolating to the Series B Capital has priority over the priority returns on the Series A Capital. The Undistributed Contributod Capital relating to the Residual Capital has priority over the priority rctums on the Series B Capital and the Series A Capital. Because Undistributed Contributed Capital is generally based on the fair value of the net assets that each partner initially contributed to the partnership, the aggregate of such amounts is significantly higher than TWE's partners' capital as reflected in the consolidated financial sta.tements, which is based on the historical cost of the contributed net assets. For purposes of allocating partnership income or loss to the partners, partnership income or loss is based on the fair value of the net assets contributed to the partnership and results in significantly less partnership income, or results in partnership losses, in contrast to the net income reported by TWE for financial statement purposes, which is also based on the historical cost of contributed net assets. Under the TWE partnership agreement, paztnership income, to the extent earned, is first allocated to the partners' capital accounts so that the economic burden of the income tax consequences of partnership operations is borne as though the paztnership were taxed as a corporarion ("special tax allocations" ). After any special tax allocations, partnership income is allocated to the Senior Capital, Series A Capital and Series B Capital, in order of priority, at rates of retum ranging from 8°7o to 13.25% per annum, and finally to the Residual Capital. Partnership losses generally are allocated first to eliminate prior allocarions of partnership income to, and then to reduce the Undistributed Contributed Capital of, the Residual Capital, Series B Capital and Series A Capital, in that order, then to reduce the Time Wazner General Partners' Senior Capital, including partnership income allocated thereto, and finally to reduce any special tax allocarions. To the extent partnership income is insu�cient to satisfy all special allocations in a particular accounting period, the right to receive additional partnership income necessary to provide for the various priority capital rates of 1�1t] TIME WARNER ENTERTAINMENT COMPANY, L.P. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS —(Continued) return is carried forward until satisfied out of future partnership income, including any partnership income that may result from any liquidation, sale or dissolution of TWE. The Series B Capital owned by subsidiaries of Time Warner may be increased if certain operating performance targets are achieved over a ten-year period ending on December 31, 2001, although it does not appear likely at this time that such targets will be achieved. In addition, MediaOne has an option to obtain up to an additional 6.33% of Series A Capital and Residual Capital interests, depending on cable operating performance. The option is exercisable at any time through May 2005 at a maximum exercise price of $1.25 billion to $1.8 billion, depending on the year of exercise. Either MediaOne or TWE may elect that the exercise price be paid with partnership interests rather than cash. Capital Distributions Distributions and loans to the partners are subject to partnership and credit agreement limitations. Generally, TWE must be in compliance with the cash flow coverage and leverage ratios, restricted payment limitations and other credit agreement covenants in order to make such distributions or loans. In 1998 and 1997, the Time Warner General Partners received $579 million and $535 million, respectively, of distributions from TWE relating to their Senior Capital interests (representing the return of $455 million of contributed capital in each period and the distribution of $124 million and $80 million, respectively, of priority capital return), which, when taken together with a$366 million distribution in 1995 (representing a portion of the priority capital retum) increased the cumulative cash distributions received from TWE on such interests to $1.5 billion. The Time Warner General Partners' remaining $603 million Senior Capital interests and any undistributed partnership income allocated thereto (based on an 8% annual rate of return) are required to be distributed on July 1, 1999. TWE reimburses Time Wanter for the amount by which the market price on the exercise date of Time Warner common stock options exercised by employees of TWE exceeds the exercise price or, with respect to options granted prior to the TWE capitalization, the greater of the exercise price and $13.88, the market price of the common stock at the time of the TWE capitalization on June 30, 1992 ("Stock Option Distributions"). TWE accrues Stock Option Distributions and a corresponding liability with respect to unexercised options when the market price of Time Warner common stock increases during the accounting period, and reverses previously accrued Stock Option Distributions and the corresponding liability when the market price of Time Warner common stock declines. Stock Option Distributions are paid when the options are exercised. At December 31, 1998 and 1997, TWE had recorded a liability for Stock Option Distributions of $1.130 billion and $417 million, respectively, based on the unexercised options and the market prices at such dates of $62.06 and $31.00, respectively, per Time Warner common share. This liability reflects the accrual of $973 million and $399 million of Stock Option Distributions in 1998 and 1997, respectively, when the market price of Time Warner common stock increased during such periods, and the reversal of $16 million of previously accrued Stock Option Distributions in 1996 when the market price of Time Warner common stock declined. TWE paid Stock Option Distributions to Time Warner in the amount of $260 million in 1998, $75 million in 1997 and $13 million in 1996. Cash distributions are required to be made to the partners to permit them to pay income taxes at statutory rates based on their allocable taxable income from TWE ("Tax Distributions"), including any taxable income generated by the Beneficial Assets, subject to limitations referred to herein. The aggregate amount of such Tax Distributions is computed generally by reference to the taxes that TWE would have been required to pay if it were a corporation. Tax Distributions are paid to the partners on a current basis. TWE paid Tax Distributions to the Time Warner General Partners in the amount of $314 million in 1998, $324 million in 1997 and $215 million in 1996. In addition to Stock Option Distributions, Tax Distributions and Senior Capital Distributions, quarterly cash distributions may be made to the partners to the extent of excess cash, as defined in the TWE partnership F-110 TIME WARNER ENTERTAINMENT COMPANY, L.P. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS —(Continued) agreement. Such cash distributions will generally be made on a priority and pro rata basis with respect to each partner's interest in the Series A Capital, Series B Capital and Residual Capital. However, cash distributions to the Time Warner General Partners with respect to their Series A Capital and Residual Capital interests will be deferred until the limited partners receive aggregate distributions (excluding Tax Distributions) of approximately $800 million. Similarly, cash distributions with respect to the Time Warner General Partners' Series B Capital interest will be defened until the limited partners receive aggregate distributions of $1.6 billion. If any such deferral occurs, a portion of the corresponding partnership income allocations with respect to such deferred amounts will be made at a rate higher than otherwise would have been the case. As of December 31, 1998, no cash distributions have been made to the limited partners. In addition, if a division of TWE or a substantial portion thereof is sold, the net proceeds of such sale, less expenses and proceeds used to repay outstanding debt, will be required to be distributed with respect to the partners' partnership interests. Similar distributions are required to be made in the event of a financing or refinancing of debt. Subject to any limitations on the incurrence of additional debt contained in the TWE partnership and credit agreements, and the Indenture, TWE may borrow funds to make distributions. In addition, in connection with the Time Warner Telecom Reorganization, TWE recorded a$191 million noncash distribution to its partners based on the historical cost of the net assets (Note 2). 9. STOCK OPTION PLANS Time Warner has various stock option plans under which Time Warner may grant options to purchase Time Warner common stock to employees of Time Warner and TWE. Such options have been granted to employees of TWE with exercise prices equal to, or in excess of, fair market value at the date of grant. Accordingly, in accordance with Accounting Principles Board Opinion No. 25, "Accounting for Stock Issued to Employees" and related interpretations, no compensation cost has been recognized by Time Wamer, nor charged to TWE, related to such stock option plans. Generally, the options become exercisable over a three- year vesting period and expire ten years from the date of grant. Had compensation cost for Time Warner's stock option plans been determined based on the fair value at the grant dates for all awards made subsequent to 1994 consistent with the method set forth under FASB Statement No. 123, "Accounting for Stock-Based Compensation" ("FAS 123"), TWE's allocable share of compensation cost would have decreased its net income to the pro forma amounts indicated below: Years Ended December 31, 1998 1997 1996 (millions) Net income: Asreported ................................................. $326 $614 $210 Pro forma . . . . .. . .. . . . . . . . . . . .. ... . . . .. . . .. . . . . . . . . . . . . . . . . . $285 $584 $193 FAS 123 is applicable only to stock options granted subsequent to December 31, 1994. Accordingly, since T'WE's compensation expense associated with such grants would generally be recognized over a three-year vesting period, the initial impact of applying FAS 123 on pro forma net income for 1996 is not comparable to the impact on pro forma net income for 1998 and 1997, when the pro forma effect of the three-year vesting period has been fully reflected. For purposes of applying FAS 123, the fair value of each option grant is estimated on the date of grant using the Black-Scholes option-pricing model with the following weighted-average assumptions used for grants to TWE employees in 1998, 1997 and 1996: dividend yields of 0.5°Io, 1% and 1°�0, respecrively; expected volatility of 21.7%, 22.2�o and 21.79'0, respectively; risk-free interest rates of 5.59'0, 6.3% and 5.7%, respectively; and expected lives of 5 years in all periods. F-111 TIME WARNER ENTERTAINMENT COMPANY, L.P. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS —(Continued) In December 1998, Time Warner completed a two-for-one common stock split. Accordingly, the following stock option information for all prior periods has been restated to give effect to this stock split. The weighted average fair value of an option granted to TWE employees during the year was $11.03, $6.09 and $5.22 for the years ended December 31, 1998, 1997 and 1996, respectively. In 1996, Time Warner granted options to certain TWE executives at exercise prices exceeding the market price of Time Warner common stock on the date of grant. These above-market options had a weighted average exercise price and fair value of $24.26 and $3.41. A summary of stock option activity with respect to employees of TWE is as follows: Balance atJanuary 1, 1996 ....................................... Granted ........................ Exercised....................................:................. Cancelled�a� .................................................... Balance at December 31, 1996 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Granted....................................................... Exercised...................................................... Cancelled�d� .................................................... Balance at December 31, 1997 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Granted....................................................... Exercised...................................................... Cancelled�a� .................................................... Balance at December 31, 1998 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Thousands of Shares 57,069 9,021 (2,485) (2,983) 60,622 7,839 (7,045) (2,412) 59,004 5,767 (15,957) (1,073) 47,741 Weighted- Average Exercise Price $16.63 2124 14.34 15.68 $17.46 20.68 14.37 16.76 $1828 37.82 16.42 14.36 $21.35 (a) Includes all options cancelled and forfeited during the year, as well as options related to employees who have been transferred out of and into TWE to and from other Time Wamer divisions. December 31, 1998 1997 1996 (thousands) Exercisable ............................................... 33,370 43,022 45,544 F-112 TIME WARNER ENTERTAINMENT COMPANY, LP. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS —(Continued) The following table summarizes information about stock options outstanding with respect to employees of TWE at December 31, 1998: Range of Exercise Prices Under $10 ................. $10.00 to $15.00 . . . . . . . . . . . . $15.01 to $20.00.... ... .. . .. $20.01 to $30.00. . . . . . . . . . . . $30.01 to $45.00. . . . . . . . . . . . $45.01 to $52.39. . . . . . . . . . . . Total..................... Options Outstanding Weighted- Average Weighted- Number Remaioing Average Outstandiag Cootractual Exercise at 12/31/98 Life Price (thousands) 374 5,183 17,035 19,254 4,582 1,313 47,741 1.1 years 2.8 years 5.2 years 5.7 years 9.0 years 9.1 years 5.6 years $ 8.37 $12.54 $18.34 $21:66 $34.70 $47.82 $21.35 Options Exercisable Weighted- Number Average Exercisable Exercise at 12/31/98 Price (thousands) 374 $ 8.37 5,183 $12.54 13,433 $18.21 14,329 $21.46 51 $30.28 33,370 $18.63 1"WE reimburses Time Warner for the use of Time Warner stock options on the basis described in Note 8. 10. BENEFIT PLANS TWE and its divisions have defined benefit pension plans covering substantially all domestic employees. Pension benefits are based on formulas that reflect the employees' years of service and cornpensation levels during their employment period. Time Warner's common stock represents approximately 12% and 7% of plan assets at December 31, 1998 and 1997, respectively. A summary of activity for TWE's defined benefit pension plans is as follows: Components of Pension Expense Service cost ................................................... Interest cost ..............................:................... Expected retum on plan assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Net amortization �and deferral . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Total........................................................ F-113 Years Ended December 31, 1998 1997 •1996 (millions) .; $.42 $ 33 $ 33 36 31 28 (35) (26)� (23) — — 3 $ 43 $ 38 $ 41 TIME WARNER ENTERTAINMENT COMPANY, LP. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS —(Continued) Change in Projected Benefit Obligation Projected benefit obligation at beginning of year . . . . . . . . . . . . . . . . . . . . . . . . . . . Servicecost .......................................................... Interest cost ....................................................... Actuarialloss ........................................ .............. Benefitspaid ......................................................... Projected benefit obligation at end of year . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Change in Plan Assets Fair value of plan assets at beginning of year . . . . . . . . . . : . . . . . . . . . . . . . . . . . . . Actual return on plan assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Employer contribution ................................................. Benefitspaid ........................................ ............... Fair value of plan assets at end of year . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Unfunded projected benefit obligation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Additional minimum liability�a� . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Unrecognized actuarial loss (gain) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Unrecognized prior service cost . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Accrued pension e.xpense .............................................. December 31, 1998 1997 (millions) $ 461 42 36 61 _�� 586 364 112 18 �� 480 (106) (4) (10) 5 $ 115) $359 33 31 48 (10) 461 284 71 19 10) 364 (97) (10) 3 8 $(96) (a) The additional minimum liability is offset fully by a corresponding intangible asset recognized in the consolidated balance sheet. December 31, 1998 1997 1996 Weighted-Average Pension Assumptions Discount rate . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 6.75% 7.25% 7.75% Expected return on plan assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 9% 9% 9% Rate of compensation increase . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 6% 6% 6% Included above are projected benefit obligations and accumulated benefit obligations for unfunded defined benefit pension plans of $39 million and $27 million as of December 31, 1998, respectively, and $29 million and $19 million as of December 31, 1997, respectively. Certain domestic employees of TWE participate in multi-employer pension plans as to which the expense amounted to $35 million in 1998, $29 million in 1997 and $30 million in 1996. Employees of TWE's operations in foreign countries participate to varying degrees in local pension plans, which in the aggregate are not significant. Certain TWE employees also participate in Time Warner's savings and profit sharing plans, as to which the expense amounted to $35 million in 1998, $30 million in 1997 and $28 million in 1996. Contributions to the savings plans are based upon a percentage of the employees' elected contributions. Contributions to the profit sharing plans are generally determined by management. 11. DERIVATIVE FINANCIAL INSTRUMENTS TWE uses derivative financial instruments principally to manage the risk that changes in exchange rates will affect the amount of unremitted or future license fees to be received from the sale of U.S. copyrighted F-114 TIME WARNER ENTERTAINI�+IENT COMPANY, LP. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS —(Continued) products abroad. The following is a summary of TWE's foreign currency risk management strategy and the effect of this strategy on TWE's consolidated financial statements. Foreign Currency Risk Management Foreign exchange contracts are used primarily by Time Warner to hedge the risk that unremitted or future license fees owed to TWE domesric companies for the sale or anticipated sale of U.S. copyrighted products abroad may be adversely affected by changes in foreign currency exchange rates. As part of its overall strategy to manage the level of exposare to the risk of foreign currency exchange rate fluctuations, Time Wamer hedges a portion of its foreign currency exposures anticipated over the ensuing twelve month period, including those related to TWE. At December 31, 1998, Time Warner had effectively hedged approximately half of TWE's estimated foreign currency exposures that principally relate to anticipated cash flows to be remitted to the U.S. over the ensuing twelve month period. To hedge this exposure, Time Warner used foreign exchange contracts that generally have maturities of three months or less, which generally will be rolled over to provide continuing coverage throughout the year. Time Warner often cioses foreign exchange sale contracts by purchasing an offsetting purchase contract Time Warner reimburses or is reimbursed by TWE for contract gains and losses related to 'TWE's foreign currency exposure. Foreign exchange contracts are placed with a number of major financial institutions in order to minimize credit risk. TWE records these foreign exchange contracts at fair value in its consolidated balance sheet and the related gains or losses on these contracts are deferred in partners' capital (as a component of comprehensive income). These deferred gains and losses are recognized in income in the period in which the related license fees being hedged are received and recognized in income. However, to the extent that any of these contracts are not considered to be perfectly effective in offsetting the change in the value of the license fees being hedged, any changes in fair value relaring to the ineffective portion of these contracts are immediately recognized in income. Gains and losses on foreign exchange contracts are generally included as a component of interest and other, net, in TWE's consolidated statement of operarions. At December 31, 1998, Time Warner had contracts. for the sale of $755 million and the purchase of $259 million of foreign currencies at fixed rates. Of Time Warner's $496 million net sale contract position, $298 million of the foreign �exchange sale contracts and $101 million of the foreign exchange purchase contracts related to TWE's foreign currency exposure, primarily Japanese yen (29% of net contract position related to TWE), French francs (29�0), German marks (32%) and Canadian dollars (5%), compared to a net sale contract position of $105 million of foreign currencies at December 31, 1997. TWE had defeaed approxi- mately $6 million of net losses on foreign exchange contracts at December 31, 1998, which is all expected to be recognized in income over the next twelve months. For the years ended December 31, 1998, 1997 and 1996, TWE recognized $2 million in losses, $14 million in gains and $6 million in gains, respectively, on foreign exchange contracts; which were or are expected to be offset by corresponding decreases and increases, respectively, in the dollar value of foreign currency license fee payments that have been or are anticipated to be received in cash from the sale of U.S. copyrighted products abroad. Time Warner places foreign currency contracts with a number of major financial institutions in order to minimize counterparty credit risk. 12. SEGMENT INFORMATION TWE classifies its business interests into three fundamental areas: Cable Networks, consisting principally of interests in cable television programming; Entertainment, consisting principally of interests in filmed entertainment, television production and television broadcasting; and Cable, consisting principally of interests in cable television systems. Information as to the operations of TWE in different business segments is set forth below based on the nature of the products and services offered. 'TWE evaluates performance based on several factors, of which the primary financial measure is business segment operating income before noncash amortization of intangible assets ("EBITA"). The accounting policies of the business segments are the same as those described in the F-115 TIME WARNER ENTERTAINMENT COMPANY, LP. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS —(Continued) summary of significant accounting policies (Note 1). Intersegment sales are .acc.ounted for at fair value as if the sales were to third parties. The operating results of TWE's cable segment reflect the TWE-A/N Transfers effective as of January 1, 1998, the Primestar Roll-up Transaction effective as of April 1, 1998, the formation of the Road Runner Joint Venture effective as of June 30, 1998 and the Time Warner Telecom Reorganization effective as of July 1, 1998. Revenues Filmed Entertainment-Warner Bros . . . Broadcasting-The WB Network . . . . . . . . . . . . Cable Networks-HBO . . . . . . . . . . . � � � � � � � � � � � Cable....... .. ........ .......... ........... Intersegment elimination . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Total...............................:....�............ EBITA�'� Filmed Entertainment-Warner Bros . . Broadcasting-The WB Network . . . . . . . . . . . . Cable Networks-HBO . . . � � � � � � � � � � � � Cable�Z� .............................................. Total................................................ Years Ended December 31, 1998 1997 1996 (millions) $ 6,051 $ 5,462 $ 5,639 260 136 87 2,052 1,923 1,763 4,378 4,243 3,851 (495) 446) 488) $12,246 $11,318 $10,852 Years Ended December 3l, 1998 Ih97 1996 (miilions) $498 $387 $367 454� 39i� 328) 1,369 1,184 917 $2,228 $1,874 $1,514 (1) EBITA represents business segment operating income before noncash amortization of intangible assets. After deducting amortization of intangible assets, TWE's business segment operating income was $1.719 billion in 1998, $1.444 billion in 1997 and $1.078 billion in 1996. (2) lncludes net gains oP approximately $90 million and $200 million recognized in 1998 and 1997, respectively, related to the sale or exchange of certain cable.television svstems. Depreciation of Property, Plant and Equipment Filmed Entertainment-Warner Bros . . . . Broadcasting-The WB Network . . . . . . . . . . . . . . . Cable Networks-HBO . . . . . . . . . . . . . . � Cable................................................ Total................................................ Amortization of Intangible Assets"� Filmed Entertainment-Warner Bros . . . Broadcasring-The WB Network ................... .... Cable Networks-HBO . . . . . . . .. . . . . Cable................................................ Total.................. ............................ Yesrs Ended December 3l, 1998 1997 1996 (millions) $166 $181 $158 1 1 — 23 22 22 737 736 619 $927 $940 $799 Years Ended December 31, 1998 1997 1996 (millions) $129 $123 $125 3 — — 377 307 311 $509 $430 $436 (1) Amortization includes amortization relating to all business combinations accounted for by the purchase method, including Time Warner's $14 billion acquisition of WCI in 1989 and $1.3 billion acquisition oF the minority interest in A7C in 1992. F-116 TIME WARIVER ENTERTAINMENT COMPANY, LP. NOT'ES TO CONSOLIDATED FINANCIAL STATEMENTS —(Continued) Information as to the assets and capital expenditures of TWE is as follows: December 31, 1998 1997 1996 (millions) Assets Filmed Entertainment-Wamer Bros . . . . . . . . . . . . . . . . . . . . . . . $ 8,800 $ 8,098 $ 8,057 Broadcasting-The WB Network . . . . . . . . . . . . . . . . . . . . . . . . . . 244 113 67 Cable Networks-HBO . .. ... ...... . .. ..... ........ . .. . .. 1,159 1,080 997 Cable .. ........................................... 11,314 10,771 10,202 Corporate�� ........................................... 713 669 650 Total ..................................... ....... . $22,230 $20,731 $19,973 ( I) Consists principally of cash, cash equivalents nnd other investments. Years Ended December 31, 1998 1997 1996 (millions) Capital Expenditures Filmed Entertainment-Warner Bros . . . . . . . . . . . . . . . . . . . . . . . . . . $ 122 Broadcasting-The WB Network ............................. 1 Cable Networks-HBO . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 23 Cable�'� ................................................. 1,451 Corporate................................................ 6 Total........................................ ...... .. $1,603 $ 144 $ 340 1 2 19 29 1,401 1,348 $1,565 $1,719 ( I) Cable capital expenditures were funded in part through collections on the MediaOne Note Receivable in the amount of $169 miilion in 1996 (Note t). The MediaOne Note Receivable was fully collected during 1996. Informarion as to TWE's operations in different geographical areas is as follows: ,, Revenues�'� United States .......................................... United Kingdom ....................................... Germany............................................. Japan................................................ France............................................... Canada.... . ..................................... Otherinternational ..................... .............. Total................................................. ( I) Revenucs are attributed to countries based on loration of customer. Yesrs Ended December 31, 1998 1997 1996 (millions) $10,167 459 263 162 163 145 887 $12,246 $ 9,086 488 284 172 152 137 999 $11,318 $ 8,718 383 374 196 143 157 881 $10,852 Because a substantial portion of TWE's international revenues is derived from the sale of U.S. copyrighted products abroad, assets located outside the United States are not material. 13. COMMTfMENTS AND CONTIIVGENCIES TWE's total rent expense amounted to $218 million in 1998, $218 million in 1997 and $205 million in 1996. The minimum rental commitments under noncancellable long-term operating leases are: 1999- $186 million; 2000-$175 million; 2001-$164 million; 2002-$155 million; 2003-$136 million; and after 2003- $736 million. F-117 TIME WARNER ENTERTAINMENT COMPANY, LP. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS —(Continued) TWE's minimum commitments and guarantees under certain programming, licensing, franchise and other agreements aggregated approximately $6.3 billion at December 31, 1998, which are payable principally over a five-year period. TWE is subject to numerous legal proceedings (including certain litigation relating to Six Flags). In management's opinion and considering established reserves, the resolution of these matters will not have a material effect, individually and in the aggregate, on TWE's financial statements. 14. RELATED PARTY TRANSACTIONS In the normal course of conducting their businesses, TWE units have had various transactions with Time Warner units, generally on terms resulting from a negotiation between the affected units that in management's view results in reasonable allocations. Employees of TWE participate in various Time Warner medical, stock option and other benefit plans for which T'WE is charged its allocable share of plan expenses, including administrative costs. In addition, Time Warner provides TWE with certain corporate services for which TWE paid a fee in the amount of $72 million, $72 million and $69 million in 1998, 1997 and 1996, respectively. TWE was required to pay a$130 million advisory fee to MediaOne over a five-year period that ended September 15, 1998 for MediaOne's expertise in telecommunications, telephony and information technology, and its participation in the management and technological upgrade of TWE's cable systems. � TWE has management services agreements with Time Wamer's Cable division, pursuant to which TWE .manages, or provides services to, the cable television systems owned by Time Warner. Such cable television systems also pay fees to TWE for the right to cany cable television programming provided by TWE's cable networks. Similarly, TWE's cable television systems pay fees �to Time Warner for the right to carry cable television programming provided by Time Warner's cable networks. TWE's Cable division has agreed to sell or exchange various cable television systems to MediaOne in an effort to strengthen its geographic clustering of cable television properties. TWE's Filmed Entertainment-Warner Bros. division has various service agreements with Time Warner's Filmed Entertainment-TBS division, pursuant to which TWE's Filmed Entertainment-Wamer Bros. division provides certain management and distribution services for Time Warner's theatrical, television and animated product, as well as certain services for administra'tive and technical support. Time Warner's Cable Networks-TBS division has license agreements with TWE, pursuant to which the cable networks have acquired broadcast rights to certain film and television product. In addition, Time Warner's Music division provides home videocassette distribution services to certain TWE operations, and certain TWE units place advertising in magazines published by Time Warner's Publishing division. Time Warner has a credit agreement with TWE that allows it to borrow up to $400 million frem TWE through September 15, 2000. Outstanding borrowings from TWE in the amount of $400 million bear interest at LIBOR plus 1% per annum. In addition to transactions with its partners, TWE has had transactions with the Columbia House Company partnerships, Comedy Partners, L.P., Time Warner Telecom, the Road Runner Joint Venture and other equity investees of Time Wamer and the Entertainment Group, generally with respect to sales of products and services in the ordinary course of business. 1"WE also has distribution and merchandising agreements with Time Warner Entertainment Japan Inc., a company owned by certain former and existing partners of TWE to conduct TWE's businesses in Japan. F-118 TIME WARNER ENTERTAINMENT COMPANY, LP. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS —(Continued) 15. ADDITIONAL FINANCIAL INFORMATION Cash Flows TWE established an asset securitization facility on December 31, 1997, which effectively provides for the accelerated receipt of up to. $500 million of cash through the year 2000 on available licensing contracts. Assets securitized under this faciliry consist of cash contracts for the licensing of theatrical and television product for broadcast network and syndicated television exhibition, under which revenues have not been recognized because such product is not available for telecast until a later date ("Backlog Contracts"). In connection with this securitization facility, TWE sells, on a revolving and nonrecourse basis, certain of its Backlog Contracts ("Pooled Backlog Contracts") to a wholly owned, special purpose entity which, in tum, sells a percentage ownership interest in the Pooled Backlog C.ontracts to a third-party, commercial paper conduit sponsored by a financial institution. Because the Backlog Contracts securitized under this facility consist of cash contracts for the licensing of theatrical and television product that have already been produced, the recognition of revenue for such completed product is only dependent upon the commencement of the availability period for telecast under the terms of the licensing agreements. Accordingly, the proceeds received under the program are classified as deferred revenues in long-term liabilities in the accompanyi�g consolidated balance sheet. Net proceeds of approximately $166 million were received under this securidzation program in 1998. Additional financial information with respect to cash flows is as follows: Cash payments made for interest . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Cash payments made for income taxes, net . . . . . . . . . . . . . . . . . . . . . . . . Noncash capital contributions (distributions), net . . . . . . . . . . . . . . . . . . . Years Ended December 31, 1998 1997 1996 (millions) $537 $493 $513 91 95 74 973 399 (1) Noncash invesring and financing activities in 1998 included the Time Warner Telecom Reorganization, the TWE-A/N Transfers, the Primestar Roll-up Transaction and the exchange of certain cable television systems (Note 2). Other Current Liabilities Other current liabilities consist of: December 31, 1998 1997 (millions) Accrued expenses ................................................... $1,395 $1,159 Accrued compensation .............................................. 298 253 Defened revenues .................................................. 249 255 Total............................................................. $1,942 $1,667 F-119 REPORT OF INDEPENDENT AUDITORS The Partners of Time Wamer Entertainment Company, L.P. We have audited the accompanying consolidated balance sheet of Time Warner Entertainment Company, L.P. ("TWE") as of ..December 31, 1998 and 1997, and the related consolidated statements of operations, cash flows and partnership capital for each of the three years in the period ended December 31, 1998. Our audits also included the financial statement schedule listed in the Index at Item 14(a). These financial statements and schedule are the responsibility of TWE's management. Our responsibility is to express an opinion on these financial statements and schedule based on our audits. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, ihe financial statements referred to above present fairly, in all material respects, the consolidated financial position of TWE at December 31, 1998 and 1997, and the consolidated results of its operations and its cash flows for each of the three years in the period ended December 31, 1998, in conformity with generally accepted accounting principles. Also, in our opinion, the related financial statement schedule, when considered in relation to the basic financial statements taken as a whole, presents fairly in all material respects the information set forth therein. New York, New York February 3, 1999 ERNSr & Yourvc LLP F-120 TIME WARNER ENTERTAINMENT COMPANY, LP. SELECTED FINANCIAL. INFORMATION The selected financial informarion for each of the five years in the period ended December 31, 1998 set forth below has been derived from and should be read in conjunction with the consolidated financial statements and other financial information presented elsewhere herein. Capitalized terms are as defined and described in such consolidated financial statements, or elsewhere herein. The selected historical financial information for 1998 reflects (a) the TWE-A/N Transfers effective as of January 1, 1998, (b) the Primestar Roll-up Transaction effective as of April 1, 1998, (c) the formation of the Road Runner Joint Venture effective as of June 30, 1998 and (d) the Time Warner Telecom Reorganization effective as of July 1, 1998. The selected historical financial information for 1995 reflects the consolidation by TWE of TWE-A/N resulting from the formation of such partnership, effective as of April 1, 1995, and the consolidation of Paragon effective as of July 6, 1995. The selected historical financial information gives effect to the deconsolidation of Six Flags resulting from the disposition by TWE of a 51% interest in Six Flags ef%ctive as of June 23, 1995. Selected Operating Statement Information Revenues ................................. Depreciation and amortization . . . . . . . . . . . . . . . . Business segment operating income�' � . . . . . . . . . Interest and other, net�Z� . . . . . . . . . . . . . . . . . . . . Income before extraordinary item . . . . . . . . . . . . . Net income�3� . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Selected Balsnce Sheet Information Cash and equivalents . . . . . . . . . . . . . . . . . . . . . . Total assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Debt due within one year ................... Long-term debt ........................... Preferred stock of subsidiary . . . . . . . . . . . . . . . . Time Warner General Partners' Senior Capital .. Partners' capital ........................... 1998 $12,246 (1,436) 1,719 (965) 326 326 Years Ended December 3l, 1997 19% 1995 1994 (miUions) $11,318 (1,370) 1,444 (345) 637 614 $10,852 (1,235) 1,078 (522) 210 210 $ 9,517 (1,039) 960 (580) 97 73 $8,460 (943) 848 (587) 161 161 December 31, 1998 1997 1996 1995 1994 (millions) $ 87 $ 322 $ 216 $ 209 $ 1,071 22,230 20,731 19,973 18,905 18,662 6 8 7 47 32 6,578 5,990 5,676 6,137 7,160 217 233 — — — 603 1,118 1,543 1,426 1,663 5,107 6,333 6,574 6,478 6,233 (1) Includes net gains of approximately $90 million and $200 million recognized in 1998 and 1997, respectively, related to the sale or exchange of certain cable television systems. (2) Includes a charge of approximately $210 million in 1998 to reduce the carrying ralue of an interest in Primestar and a gain of approximately $250 million in 1997 related to the sale of an interat in E! Entertainment. (3) Net income for each of the years ended December 31, 1997 and 1995 includes dn extraordinary loss on the retirement of debt of $23 million and $24 miUion, respectively. F-121 TIME WARNER ENTERTAINMENT COMPANY, LP. QUARTERLY FINANCIAL INFORMATION (UNAUDITED) Quarter 1998 lst............................................................ 2nd�d� ......................................................... 3rd............................................................ 4th�b� .......................................................... Year�a��D� ...................................................... 1997 lst�`� .......................................................... 2nd........................................................... 3rd............................................................ 4th�d�,(e> ........................................................ Year.......................................................... Operating � Income of Business Revenues Segments (millions) $ 2,910 $ 369 2,850 455 3,220 468 3,266 427 12,246 1,719 $ 2,600 2,728 2,855 3,135 11,318 $ 329 320 335 460 1,444 Net income (loss) $ 108 155 172 (109) 326 $ 320 82 81 131 614 (a) Operating income includes net gains of approximately $90 million for the year relating to the sale or exchange of certain cable television systems, of which approximately $70 million was recorded in the second quarter oF 1998. (b) Net income (loss) for the fourth quarter of 1998 includes a charge of dpproximately $210 million principally to reduce the carrying value of an interest in Primestar. (c) Net income in the first quarter of 1997 includes a gain of approximately $250 million related to the sale of an interest in E! Entertainment. (d) Operating income for 1997 includes net gains of approximately $200 million for the year relating to the sale or exchange of certain cable television systems, of which approximately $160 million was recorded in the fourth quarter of 1997. (e) Net income for the %urth quarter of 1997 includes an extraordinary loss on the retirement of debt of $23 million. F-122 TIME WARNER ENTERTAINMENT COMPANY, LP. SCHEDULE II— VALUATION AND QUALIFYING ACCOUNTS Years Ended December 31, 1998, 1997 and 1996 Additions Balance at Charged to Beginning Costs and Description of Period Expenses Deductions (millions) 1998: Reserves deducted from accounts receivable: Allowance for doubtful accounts . . . . . . . . . . . . . . . . . . Reserves for sales retums and allowances . . . . . . . . . . . Total........................................... 1997: Reserves deducted from accounts receivable: Allowance for doubtful accounts . . . . . . . . . . . . . . . . . . Reserves for sales retums and allowances . . . . . . . . . . . Total........................................... 1996: Reserves deducted from accounts receivable: Allowance for doubtful accounts . . . . . . . . . . . . . . . . . . Reserves for sales returns and allowances . . . . . . . . . . . Total........................................... (a) Represents uncollectible receivables charged against the reserve. (b) Represents returns or allowances applied against the reserve. F-123 Balance At End of Period $218 $144 $ (91) �� $271 206 338 (309)�b� 235 $424 $482 �400) $506 $195 178 $373 $113 289 $402 $ (90) ca) �61) cb' �351) $218 206 $424 $196 $ 97 $ (98)�d� $195 169 278 �269) �b� 178 $365 $375 $(367) $373 Exhibit Number 3.(i) (a) 3. (i) (b) 3. (i) (c) EXHIBIT INDEX Description Restated Certificate of Incorporation of the Registrant as filed with the Secretary of State of the State of Delaware on October 10, 1996 (which is incorporated herein by reference to Exhibit 4.3 to the Registrant's Post-Effective Amendment No. 1 on Form S-8 to the Registrant's Registration Statement on Form S-4 fited with the Commission on October 11, 1996 (Registration No. 333-11471) (the "S-8 Registration Statement") ). Certificate of Increase of the Number of Shares of Series Common Stock of .the Registrant Designated as Series LMCN-V Common Stock as filed with the Secretary of State of the State of Delaware on Augusi 13, 1997 (which is incorporated herein by reference to Exhibit 3.(i) (b) to the Registrant's Quarterly Report on Form 10-Q for the quarter ended September 30, 1997). Certificate of Amendment of Restated Certificate of Incorporation of the Registrant as filed with the Secretary of State of the State of Delaware on May 19, 1997 (which is incorporated herein by reference to Exhibit 3.(i) (c) to the Registrant's Quarterly Report on Form 10-Q for the quarter ended June 30, 1997 ( the "June 1997 Form 10-Q") ). 3.(i)(d) Certificate of Amendment of Restated Certificate of Incorporation of the Registrant as filed with the Secretary of State of the State of Delaware on October 10, 1996 (which is incorporated herein by reference to Exhibit 4.4 to the Registrant's S-8 Registration Statement). 3.(i) (e) Certificate of the Voting Powers, Designations, Preferences and Relarive, Participating, Optional or Other Special Rights, and Qualifications, Limitations or Restrictions Thereof, of Series LMC Common Stock of the Registrant as filed with the Secretary of State of the State of Delaware on October 10, 1996 (which is incorporated herein by reference to Exhibit 4.5 to the Registrant's S-8 Registration Statement). 3.(i) (f� 3. (i) (g) 3. (i) (h) Certificate of the Voting Powers, Designations, Preferences and Relarive, Participating, Optional or Other Special Rights, and Qualifications, Limitations or Restrictions Thereof, of Series LMCN-V Common Stock of the Registrant as filed with the Secretary of State of the State of Delaware on October 10, 1996 (which is incorporated herein by reference to Exhibit 4.6 to the Registrant's S-8 Registration Statement). . Certificate of the Voting Powers, Designations, Preferences and Relative, Participating, Optional or Other Special Rights, and Qualifications, Limitations or Restrictions Thereof, of Series A Participating Cumulative Preferred Stock of the Registrant as filed with the Secretary of State of the State of Delaware on October 10, 1996 (which is incorporated herein by reference to Exhibit 4.7 to the Regisuant's S-8 Registration Statement). Certificate of the Voting Powers, Designations, Preferences and Relative, Participating, Optional or Other Special Rights, and Qualifications, Limitations or Restrictions Thereof, of Series D Convertible Preferred Stock of the Registrant as filed with the Secretary of State of the State of Delaware on October 10, 1996 (which is incorporated herein by reference to Exhibit 4.8 to the Registrant's S-8 Registration Statement). Sequential Page Number Exhibit Sequential Number Page Description Number 3. (i) (i) 3. (i) (j) 3. (i) (k) 3. (i) (1) 3.(i) (m) 3. (i) (n) 3. (i) (o) Certificate of the Voting Powers, Designations, Preferences and Relative, Participating, Optional or Other Special Rights, and Qualifications, Limitations or Restrictions Thereof, of Series E Convertible Preferred Stock of the Registrant as filed with the Secretary of State of the State of Delaware on October 10, 1996 (which is incorporated herein by reference to Exhibit 4.9 to the Registrant's S-8 Registration Statement). Certificate of Correction of the Certificate of the Voting Powers, Designations, Preferences and Relative, Participating, Optional or Other Special Rights, and Qualifications, Limitations or ltestrictions Thereof, of Series E Convertible Preferred Stock of the Registrant as filed with the Secretary of State of the State of Delaware on November 13, 1996 (which is incorporated herein by reference to Exhibit 3.i(h) to the Registrant's Annual Report on Form 10-K for the year ended December 31, 1996 (the "1996 Rorm 10-K") ). Certificate of the Voting Powers, Designations, Preferences and Relative, Participating, Optional or Other Special Rights, and Qualificarions, Limitations or Restrictions Thereof, of Series F Convertible Preferred Stock of the Registrant as filed with the Secretary of State of the State of Delaware on October 10, 1996 (which is incorporated herein by reference to Exhibit 4.10 to the Registrant's S-8 Registrarion Statement). Certificate of Correction of the Certificate of the Voting Powers, Designations, Preferences and Relative, Participating, Optional or Other Special Rights, and Qualifications, Limitations or Restrictions Thereof, of Series F Convertible Preferred Stock of the Registrant as filed with the Secretary of State of the State of Delawaze on November 13, 1996 (which is incorporated herein by reference to Exhibit 3.(i)(j) of the RegistranYs 1996 Form 10-K). Certificate of Elimination of the Certificate of the Voting Powers, Designations, Preferences and Relative, Participating, Optional or Other Special Rights and Qualifications, Limitations or Restrictions Thereof, of Series G Convertible Preferred Stock of the Registrant as filed with the Secretary of State of the State of Delaware on March 18, 1999. Certificate of the Voting Powers, Designations, Preferences and Relative, Participating, Optional or Other Special Rights, and Qualifications, Limitarions or Restrictions Thereof, of Series G Convertible Preferred Stock of the Registrant as filed with the Secretary of State of the State of Delaware on October 10, 1996 (which is incorporated herein by reference to Exhibit 4.11 to the Registrant's S-8 Registration Statement). Certificate of Elimination of the Certificate of the Voting Powers, Designations, Preferences and Relative, Participating, Optional or Other Special Rights and Qualifications, Limitations or Restrictions Thereof, of Series H Convertible Preferred Stock of the Registrant as filed with the Secretary of State of the State of Delawaze on Mazch 18, 1999. 3. (i) (p) Certificate of the Voting Powers, Designarions, Preferences and Relarive, Participating, Optional or Other Special Rights, and Qualifications, Limitations or Restricrions Thereof, of Series H ConveRible Preferred Stock of the Registrant as filed with the Secretary of State of the State of Delaware on October 10, 1996 (which is incorporated herein by reference to Exhibit 4.12 to the Registrant's S-8 Registration Statement). � Exhibit Sequential Pa e Number Description Number 3. (i) (q) Certificate of the Voting Powers, Designations, Preferences and Relative, Participating, Optional or Other Special Rights, and Qualifications, Limitations or Restrictions Thereof, of Series I Convertible Preferred Stock of the Registrant as filed with the Secretary of State of the State of Delaware on October 10, 1996 (which is incorporated herein by reference to Exhibit 4.13 to the Registrant's S-8 Registration Statement). 3.(i) (r) Certificate of the Voting Powers, Designations, Preferences and Relative, Participating, Optional or Other Special Rights, and Qualifications, Limitations or Restrictions Thereof, of Series J Convertible Preferred Stock of the Registrant as filed with the Secretary of State of the State of Delaware on October 10, 1996 (which is incorporated herein by reference to Exhibit 4.14 to the Registrant's S-8 Registration Statement). 3.(i) (s) Certificate of Elimination of the Voting Powers, Designations, Preferences and Relative, Participating, Optional or Other Special Rights, and Qualifications, Limitations or Restrictions Thereof, of 10'/a% Series M Exchangeable Preferred Stock of the Registrant as filed with the Secretary of State af the State of Delaware on March 18, 1999. 3.(i) (t) Certificate of the Voting Powers, Designations, Preferences and Relative, Participating, Optional or Other Special Rights, and Qualifications, Limitations or Restricrions Thereof, of 10'/a% Series M Exchangeable Preferred Stock of the Registrant as filed with the Secretary of State of the State of Delaware on October 10, 1996 (which is incorporated herein by reference to Exhibit 4.15 to the Registrant's S-8 Registration Statement). 3.(ii) By-laws of the Registrant as of November 19, 1998. 4.1 Rights Agreement (the "Rights Agreement") dated as of October 10, 1996 between the Registrant and ChaseMellon Shareholder Services L.L.C. ("ChaseMellon") (which is incorporated herein by reference to Exhibit 4.17 to the Registrant's S-8 Registration Statement). 4.2 Amendment No. 1 to the Rights Agreement dated as of December I5, 1998 between the Registrant and ChaseMellon. 4.3 Amendment No. 2 to the Rights Agreement dated as of January 21, 1999 between the Registrant and ChaseMellon. 4.4 Indenture dated as of June 1, 1998 among the Registrant, Time Wamer * Companies, Inc. ("TWCI"), Tumer Broadcasting System, Inc. ("TBS") and The Chase Manhattan Bank, as Trustee ("Chase Manhattan") (which is incorporated herein by reference to Exhibit 4 to the Registrant's Quarterly Report on Form 10-Q for the period ended June 30, 1998). 4.5 Indenture dated as of April 30, 1992, as amended by the First Supplemental * Indenture, dated as of June 30, 1992, among Time Warner Entertainment Company, L.P. ("TWE"), TWCI, certain of TWCI's subsidiaries that are parties thereto and The Bank of New York ("BONY"), as Trustee (which is incorporated herein by reference to Exhibits 10(g) and 10(h) to TWCI's Current Report on Form 8-K dated July 14, 1992 (File No. 1-8637) ("TWCI's July 1992 Form 8-K") ) . � Sequential Exhibit Page Number Description Number 4.6 Second Supplemental Indenture, dated as of December 9, 1992, among TWE, TWCI, certain of TWCI's subsidiaries that are parties thereto and BONY, as Trustee (which is incorporated herein by reference to Exhibit 4.2 to Amendment No. 1 to TWE's Registration Statement on Form S-4 (Registration No. 33-67688) filed with the Commission on October 25, 1993 ("TWE's 1993 Form S-4")). 4.7 Third Supplemental Indenture, dated as of October 12, 1993, among TWE, TWCI, certain of TWCI's subsidiaries that are parties thereto and BONY, as Trustee (which is incorporated herein by reference to Exhibit 4.3 to TWE's 1993 Form S-4). 4.8 Fourth Supplemental Indenture, dated as of March 29, 1994, among TWE, TWCI, certain of TWCI's subsidiaries that are parties thereto and BONY, as Trustee (which is incorporated herein by reference to Exhibit 4.4 to T'WE's Annual Report on Form 10-K for the year ended December 31, 1993 (File No. 1-12259) ("TWE's 1993 Form 10-K")). 4.9 Fifth Supplemental Indenture, dated as of December 28, 1994, among TWE, TWCI, certain of TWCI's subsidiaries that are parties thereto and BONY, as Trustee (which is incorporated herein by reference to Exhibit 4.5 to TWE's Annual Report on Form 10-K for the year ended December 31, 1994 (File No. 1-12259)). 4.10 Sixth Supplementa[l Indenture, dated as of Septembe.r 29, 1997, among TWE, TWCI, certain of TWCI's subsidiaries that are parties thereto and BONY, as Trustee (which is incorporated herein by reference to Exhibit 4.7 to the Registrant's Annual Report on Form 10-K for the year ended December 31, 1997 (the "1997 Form 10-K)). 4.11 Seventh Supplemental Indenture, dated as of December 29, 1997, among TWE, TWCI, certain of TWCI's subsidiaries that are parties thereto and BONY, as Trustee (which is incorporated herein by reference to Exhibit 4.7 to the Registrant's 1997 Form 10-K). 4.12 Indenture dated as of January 15, 1993 between TWCI and Chase Manhattan, as Trustee (which is incorporated herein by reference io Exhibit 4.11 to TWCI's Annual Report on Form 10-K for the year ended December 31, 1992 (File No. 1-8637) ). 4.13 First Supplemental Indenture dated as of June 15, 1993 between TWCI and Chase Manhattan, as Trustee (which is incorporated herein by reference to Exhibit 4 to TWCI's Quarterly Report on Form 10-Q for the quarter ended June 30, 1993 (File No. 1-8637)). 4.14 Second Supplemental Indenture dated as of October 10, 1996 among the Registrant, TWCI and Chase Manhattan, as Trustee (which is incorporated herein by reference to Exhibit 4.1 to TWCI's Quarterly Report on Form 10.Q for the quarter ended September 30, 1996). 4.15 Third Supplemental Indenture dated as of December 31, 1996 among the Registrant, TWCI and Chase Manhattan, as Trustee (which is incorporated herein by reference to Exhibit 4.10 to the Registrant's 1996 Form 10-K). iv Exhibit Sequential Page N umber Description N umber 4.16 Fourth Supplemental Indenture dated as of December 17, 1997 among the Registrant, TWCI, Turner Broadcasting System, Inc. ("TBS") and Chase Manhattan, as Trustee (which is incorporated herein by reference to Exhibit 4.4 to the Registrant's, TWCI's and TBS's Registrarion Statement on Form S-4 (Registration Nos. 333-45703, 333-45703-02 and 333-45703-01) filed with the Commission on February 5, 1998 (the "1998 Form S-4"). 4.17 Fifth Supplemental Indenture dated as of January 12, 1998 among the Registrant, TWCI, TBS and Chase Manhattan, as Trustee (which is incorporated herein by reference to Exhibit 4.5 to the Registrant's, TWCI's and TBS's 1998 Form S-4). 4.18 Sixth Supplemental Indenture dated as of March 17, 1998 among the Registrant, TWCI, TBS and Chase Manhattan, as Trustee (which is incorporated herein by reference to Exhibit 4.15 to ihe Registrant's 1997 Form 10-K). 4.19 Trust Agreement dated as of April 1, 1998 among the Registrant, as Grantor and U.S. Trust Company of California, N.A, as Trustee (which is incorporated herein by reference to Exhibit 4.16 to the Registrant's 1997 Form 10-K). 10.1 Time Warner 1986 Stock Option Plan, as amended through March 20, 1997 (which is incorporated herein by reference to Exhibit 10.1 to the Registrant's 1997 Form 10-K). 10.2 1988 Stock Incentive Plan of Time Wamer Inc., as amended through March 20, 1997 (which is incorporated herein by reference to Exhibit 10.2 to the Registrant's 1997 Form 10-K ) . 10.3 Time Warner 1989 Stock Incentive Plan, as amended through March 20, 1997 (which is incorporated herein by reference to Exhibit 10.3 to the Registrant's 1997 Form 10-K). 10.4 Time Warner 1994 Stock Option Plan, as amended through November 19, 1998. 10.5 Time Warner Corporate Group Stock Incentive Plan, as amended through March 20, 1997 (which is incorporated herein by reference to Exhibit 10.5 to the Registrant's 1997 Form 10-K). 10.6 Time Warner 1997 Stock Option Plan (which is incorporated herein by reference to Annex A to the Registrant's definitive Proxy Statement dated March 28, 1997 used in connection with the Registrant's 1997 annual meeting of stockholders). 10.7 Time Warner 1988 Restricted Stock Plan for Non-Employee Directors, as amended through November 18, 1993 (which is ixcorporated herein by reference to Exhibit 10.8 of TWCI's Annual RepoR on Form 10-K for the year ended Decemb.er 31, 1993 (File No. 1-8637) ("TWCI's 1993 Form 10-K")). 10.8 Time Warner 1996 Stock Option Plan for Non-Employee Directors (which is incorporated herein by reference to Annex A to TWCI's definitive Proxy Statement dated March 29, 1996 used in connection with TWCI's 1996 Annual Meeting of Stockholders). 10.9 Deferred Compensation Plan for Directors of Time Warner, as amended through November 18, 1993 (which is incorporated herein by reference to Exhibit 10.9 to TWCI's 1993 Form 10-K (File No. 1-8637)). 10.10 Time Wamer Retirement P.lan for Outside Directors, as amended through May 16, 1996 (which is incorporated herein by reference to Exhibit 10.9 to the Registrant's 1996 Form 10-K ) . Exhibit Sequential Page Number Description Number 10.11 Amended and Restated Time Warner Inc. Annual Bonus Plan for Executive Officers (which is incorporated herein by reference to Annex A to TWCI's definitive Proxy Statement dated March 30, 1995 used in connection with TWCI's 1995 Annual Meeting of Stockholders). 10.12 Time Warner Inc. Deferred Compensation Plan (which is incorporated herein by reference to Exhibit 4 to the Registrant's Registration Statement on Form S-8 filed with the Commission on December 18, 1998 (Registration No. 333-69161) ). 10.13 Amended and Restated Employment Agreement effective as of January 1, 1998, as amended December 2, 1998, between the Registrant and Gerald M. Levin. 10.14 Amended and Restated Employment Agreement effective as of January 1, 1998, as amended December 15, 1998, between the Registrant and R.E. Turner ("Turner"). 10.15 Amended and Restated Employment Agreement effective as of January 1, 1999, between the Registrant and Richard D. Parsons. 10.16 Amended and Restated Employment Agreement eSective as of January 1, 1998, as amended December 2, 1998, between the Registrant and Peter R. Haje. 10.17 Amended and Restated Employment Agreement effective as of January 1, 1999, between the Registrant and Richard J. Bressler. 10.18 Amended and Restated Employment Agreement effective as of April 1, 1998, as amended December 2, 1998, between the Registrant and Timothy A. Boggs. 10.19 Amended and Restated Employment Agreement effective as of April 1, 1998, as amended December 2, 1998, between the Registrant and John A. LaBazca. 10.20 Employment Agreement effective as of January 11, 1999, between the Registrant and Andrew J. Kaslow. 10.21 Second Amended and Restated LMC Agreement dated as of September 22, 1995 among TWCI, Liberty Media Corporation ("LMC"), TCI Turner Preferred, Inc. ("TCITP"), Communication Capital Corp. ("CCC") and United Cable. Turaer Investment, Inc. (which is incorporated herein by reference to Exhibit 10(a) to TWCI's Current Report on Form 8-K dated September 6, 1996 ("TWCI's September 1996 Form 8-K") ). 10.22 Agreement Containing Consent Order dated August 14, 1996 among TWCI, TBS, Tele-Communications, Inc., LMC'' and the Federal Trade Commission (which is incorporated herein by reference to Exhibit 2(b) to TWCI's September 1996 Form 8-K). 10.23 Stockholders' Agreement dated as of October 10, 1996 among the Registrant, Tumer, TCITP, Liberty Broadcasring Inc. CCC, Tumer Outdoor Inc. ("Tumer Outdoor") and Tumer Partners, L.P. ("Tumer's Partners") (which is incorporated herein by reference to Exhibit 10.22 to the Regisirant's 1996 Form 10-K). 10.24 Investors Agreement (No. 1) dated as of October 10, 1996 among the Registrant, Tumer, Turner Outdoor and Turner Partners (which is incorporated herein by reference to Exhibit 10.23 to the Registrant's 1996 Form 10-K). 10.25 Investors Agreement (No. 2) dated as of October 10, 1996 among the Registrant, Turner Foundation, Inc. ("Turner Foundation") and Robert E. Turner Charitable Remainder Unitrust No. 2("Turner Trust") (which is incorporated herein by reference to Exhibit 10.24 to the Registrant's 1996 Form 10-K). vi Exhibit Sequential Page Number Description Number 10.26 Registration Rights Agreement dated as of October 10, 1996 among the Registrant, Tumer, Turner Outdoor, Turner Foundation, Turner Trust and Turner Partners (which is incorporated herein by reference to Exhibit 10.25 to the Registrant's 1996 Form 10-K). 10.27 Credit Agreement dated as of November 10, 1997 among the Registrant, TWCI, 1"WE, TBS, Time Warner Entertainment-Advance/Newhouse Partnership ("T'WE-A/N Partnership") and TWI Cable Inc., �as Credit Parties, Chase Manhattan, as Administrative Agent, Bank .of America National Trust and Savings Association, BONY and Morgan Guaranty Trust Company of New York, as Documentation and Syndication Agents and Chase Securities Inc., as Arranger (which is incorporated herein by reference to Exhibit 10.26 to the Registrant's 1997 Form 10-K). 10.28 Agreement of Limited Partnership, dated as of October 29, 1991, as amended by the Letter Agreement, dated February 11, 1992, and the Letter Agreement dated June 23, 1992, among TWCI and certain of its subsidiaries, ITOCHU Corporation ("ITOCHU") and Toshiba Corporation ("Toshiba") ("TWE Partnership Agreement, as amended") (which is incorporated herein by reference to Exhibit (A) to TWCI's Current Report on Form 8-K dated October 29, 1991 (File No. 1-8637) and Exhibit 10(b) and 10(c) to TWCI's July 1992 Form 8-K). 10.29 Admission Agreement, dated as of May 16, 1993, between TWE and US WEST, Inc. ("US West") (which is incorporated herein by reference to Exhibit 10(a) to TWE's Current Report on Form 8-K dated May 16, 1993 (File No. .1-2878)). 1030 Amendment Agreement, dated as of September 14, 1993, among ITOCHU, Toshiba, TWCI, US West and certain of their respective subsidiaries, amending the TWE Partnership Agreement, as amended (which is incorporated herein by reference to Exhibit 3.2 to TWE's 1993 Form 10-K (File No. 1-2878)). 10.31 Restructuring Agreement dated as of August 31, 1995 among TWCI, ITOCHU . and ITOCHU Entertainment Inc. (which is incorporated herein by reference to Exhibit 2(a) to TWCI's Current Report on Form 8-K dated August 31, 1995 ("TWCI's August 1995 Form 8-K")). 10.32 Restructuring Agreement dated as of August 31, 1995 between TWCI and Toshiba (including Form of Registration Rights Agreement, between TWCI and Toshiba) (which is incorporated herein by reference to Exhibit 2(b) to TWCI's August 1995 Form 8-K). 10.33 Option Agreement, dated as of September 15, 1993, between TWE and US West (which is incorporated herein by reference to Exhibit 10.9 to TWE's 1993 Form 10-K (File No. 1-2878)). 10.34 Contribution Agreement dated as of September 9, 1994 among TWE, Advance Publications, Inc. ("Advance Publications"), Newhouse Broadcasting Coiporation ("Newhouse"), Advance/Newhouse Partnership ("Advance/Newhouse"), and TWE-AN Partnership (which is incorporated herein by reference to Exhibit 10(a) to TWE's Current Report on Form 8-K dated September 9, 1994 ("TWE's September 1994 Form 8-K") ). 10.35 Partnership Agreement, dated as of September 9, 1994, between TWE and Advance/Newhouse (which is incorporated herein by reference to Exhibit 10(b) to TWE's September 1994 Form 8-K). vii Sequential Exhibit Page Number Description Number 10.36 Letter Agreement.dated April 1, 1995 among TWE, Advance/Newhouse, Advance Publications and Newhouse (which is incorporated herein by reference to Exhibit 10(c) to TWE's Current Report on Form 8-K dated April 1, 1995). 10.37 Amended and Restated Transaction Agreement, dated as of October 27, 1997 among Advance Publications, Advance/Newhouse, TWE, TW Holding Co. and TWE-AN Partnership (which is incorporated herein by reference to Exhibit 99(c) to the Registrant's Current Report on Form 8-K dated October 27, 1997). 10.38 Transaction Agreement No. 2 dated as of June 23, 1998 among Advance Publications, Newhouse, Advance/Newhouse, TWE, Paragon Communications ("Paragon") and TWE-AN Partnership. 10.39 Transaction Agreement No. 3 dated as of September 15, 1998 among Advance Publications, Newhouse, Advance/Newhouse, TWE, Paragon and TWE-AN Partnership. 10.40 First Amendment to the Partnership Agreement of TWE-AN Partnership dated as of February 12, 1998 among TWE, Advance/Newhouse and TW Holding Co. 10.41 Second Amendment to the Partnership Agreement of TWE-AN Partnership dated as of December 31, 1998 among TWE, Advance/Newhouse and Paragon. 10.42 Third Amendment to the Partnership Agreement of TWE-AN Partnership dated as of Mazch 1, 1999 among TWE, Advance/Newhouse and Paragon. 21 Subsidiaries of the Registrant. 23 Consent of Emst & Young LLP, Independent Auditors. 27 Financial Data Schedule. 99.1 Annual Report on Form 11-K of the Time Wamer Savings Plan for the year ended December 31, 1998 (to be filed by amendment). 99.2 Annual Report on Form 11-K of the Time Warner Thrift Plan for the year ended December 31, 1998 (to be filed by amendment). 993 Annual Report on Form 11-K of the T'WC Savings Plan for the year ended December 31, 1998 (to be filed by amendment). * Incorporated by reference. The Registrant hereby agrees to furnish to the Securities and Exchange Commission at its request copies of long-term debt instruments defining the rights of holders of outstanding long-term debt that are not required to be filed herewith. viii EXHIBTT 21 SUBSIDIARIES OF TIME WARNER INC. Set forth below are the names of certain subsidiaries, at least 50% owned, directly or indirectly, of Time Warner and TWE as of December 31, 1998, unless otherwise indicated. Certain subsidiaries which when considered in the aggregate would not constitute a significant subsidiary are omitted from the list below. Indented subsidiaries are direct subsidiaries of the company under which they are indented. Name TIME WARNER INC. (Registrant): Turner Broadcasting System, Inc . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Turner Arena Productions and Sales, Inc . . . . . . . . . . . . . . . . . . . . . . . Atlanta Coliseum, Inc . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . The Omni Promotions Management Company . . . . . . . . . . . . . . . . Seats,Inc . .............................................. Aflanta Hockey Club, Inc . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Atlanta National League Baseball Club, Inc . . . . . . . . . . . . . . . . . . . . Hawks Basketball, Inc . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Atlanta Hawks, L.P . ...................................... CNN Investment Company, Inc . . . . . . . . . . . . . . . . . . . . . . . . . . . . : . Cable News Network LP, LLLP . . . . . . . . . . . . . . . . . . . . . . . . . . . . CNNProductions,Inc . ................................... Cable News International, Inc . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . CNNAmerica, Inc . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . CNN Germany, Inc . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . CNNNewsource Sales,Inc . ................................. Castle Rock Entertainment, Inc . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Castle Rock Entertainment . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Goodwill Games, Inc . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . HB Holding Co . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Hanna-Barbera Entertainment Co., Inc . . . . . . . . . . . . . . . . . . . . . . New Line Cinema Corporation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Turner Entertainment Group, Inc . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Tumer Entertainment Networks, Inc . . . . . . . . . . . . . . . . . . . . . . . . . Turner Entertainment Networks Asia, Inc . . . . . . . . . . . . . . . . . . TEN Investment Company, Inc . . . . . . . . . . . . . . . . . . . . . . . . . . . Turner Network Television LP, LLLP . . . . . . . . . . . . . . . . . . . The Cartoon Network LP, LLLP . . . . . . . . . . . . . . . . . . . . . . . Turner Classic Movies LP, LLLP . . . . . . . . . . . . . . . . . . . . . . . TNT Productions, Inc . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Superstation,Inc . ...................................... Tumer Original Productions, Inc . . . . . . . . . . . . . . . . . . . . . . . . Tumer Home Entertainment, Inc . . . . . . . . . . . . . . . . . . . . . . . . . . . Tumer Leaming, Inc . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Turner Publishing,Inc ................................... Turner Pictures Group, Inc . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Turner Entertainment Co . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Peroentage Owned hy Immediate Parent lU0 100 100 100 100 100 100 100 100 100 100 100 100 100 100 100 100 100 100 100 100 100 100 100 100 100 100 100 100 100 100 100 100 100 100 100 100 (1) i2) (3) (3) (3) State or Other Jurisdictio� of Incorporation or Organization Delaware Georgia Georgia Georgia Georgia Georgia Georgia Georgia Georgia Georgia Delawaze Delaware Georgia Delaware Delaware Georgia Georgia Georgia �alifornia Georgia Delaware California Delaware Georgia Georgia Georgia Delaware Delaware Delaware Delaware Georgia Georgia . Georgia Georgia Georgia Georgia Georgia Georgia Name H-B Distribution Co . ..........................:........ TBS Funding Corp . ...................... ................ Turner Broadcasting Sales, Inc . . . . . . . . . . . . . . . . . . . . . . . . . . . Turner Broadcasting System Asia Pacific, Inc : . . . . . . . . . . . . . . . . . . Turner Home Satellite, Inc . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Turner Broadcasting System Limited . . . . . . . . . . . . . . . . . . . . . . . . . . Tumer International Advertising Sales Limited . . . . . . . . . . . . . . . . Turner International Network Sales Limited . . . . . . . . . . . . . . . . . . Tumer Intemational, Inc . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Turner Network Sales, Inc . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Turner Omni Venture, Inc . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . ICC Ventures,Inc . ......................................... CNN Center Ventures .................................... Turner Private Networks, Inc . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Turner Properties, Inc . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Tnrner Sports,Inc . ......................................... Tumer Sports International Enterprises, Inc . . . . . . . . . . . . . . . . . . World Championship Wrestling,Inc . . . . . . . . . . . . . . . . . . . . . . . . . . . . Time Warner Companies, Inc . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Asiaweek Limited ..................................... .. Sunset Publishing Corporation ................................ Time Intemational Inc . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Time Inc.(5) .............................................. American Famil� Enterprises (partnership) . . . . . . . . . . . . . . . . . . . Book-of-the-Month Club, Inc . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Entertainment Weekly, Inc . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Little, Br,own and Company (Inc.) ... .. . .. . . . . . . . . . . . ... . . . . Time Distribution Services, Inc . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Time Customer Service, Inc . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Time Publishing Ventures, Inc . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Southern Progress Corporation(6) ........................ Time Inc. Ventures ....................................... Health Publications, Inc . . . . . . . . . . . . . . . . . . . : . . . . . . . . . . . . . Hippocrates Partners (partnership) . . . . . . . . . . . . . . . . . . . . . . TWC Ventures ........................................... Time Life Inc . .................................... ...:. Time-Life Customer Service, Inc . . . . . . . . . . . . . . . . . . . . . . . . . Wamer Books, Inc. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . : Warner Publisher Services Inc . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Time Warner Telecom LLC(7) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1 W Service Holding I, L.P. (partnership) . . . . . . . . . . . . . . . . . . . . . . TW Service Holding II, L.P. (partnership) . . . . . . . . . . . . . . . . . . . . . TW Programming Co. (partnership) . . . . . . . . . . . . . . . . . . . . . . . . . "TW Cable Service Co. (partnership) . . . . . . . . . . . . . . . . . . . . . . . . Time Wamer Connect (partnership) . . . . . . . . . . . . . . . . . . . . . . . . . WCI Record Club Inc . ..................................... � Percentage Owned by immediate Parent 100 100 100 100 100 100 100 100 100 100 100 100 100 100 100 100 100 100 100 80 100 100 100 50 100 100 100 100 100 100 100 100 100 50 100 100 100 10(l 100 �8) (9) (9) (10) (11) (11) 100 (4) (12) State or Other Jurisdiction of incorporation or Organization Georgia Georgia Georgia Georgia Georgia U.K. U.K. U.K. Georgia Georgia Georgia Georgia Georgia Georgia Georgia Georgia Georgia Georgia Delaware Hong Kong Delaware Delaware Delaware New York New York Delaware Massachusetts Delaware Delawaze Delaware Delaware Delaware Delaware Califomia Delaware Delaware Delaware New York New York Delaware Delaware Delaware New York New York New York Delaware Name The Columbia House Company (partnership) . . . . . . . . . . . . . . . . . Warner Communications Inc .. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Elektra Entertainment Group Inc . . . . . . . . . . . . . . . . . . . . . . . . . . . . . DC Comics (partnership) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Warner-Tamerlane Publishing Corp . . . . . . . .. . . . . . . . . . . . . . . . . . . WB Music Corp ............................................ HBOFilm Management, Inc . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . NPP Music Corp . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Warner/Chappell Music, Inc . . . . . . . .. . . . . .. . .. . .. . . . . . . . . . . . . Warner Bros. Music International Inc . . . . . . . . . . . . . . . . . . . . . . . . Warner Bros. Publications U.S. Inc . . . . . . . . . . . . . . . . . . . . . . . . New Chappell Inc.(14) ................................ Super Hype Publishing, Inc . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Cotillion Music, Inc . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Walden Music,Inc . ...................................... Summy-Birchard,Inc . .................................... CPP/Belwin,Inc . ........................................ Lorimar Motion Picture Management, Inc . . . . . . . . . . . . . . . . . . . . . . E.C. Publications, Inc . .. .... . .. .. .. . . .. . .. . .. ... . . . . . . . . . . . . Warner Music Group Inc . ................................... Warner Bros. Records Inc .................................... WBR/Sire Ventures Inc . .................................. SR/MDM Venture Inc . . . . . . . . . . . . . . ... . . . . . . . . . . . . . . . . . Maverick Recording Company (partnership) . . . . . . . . . . . . . . Atlantic Recording Corporation ................... ........ Atlantic Rhino Ventures Inc . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Warner-Elektra-Atlantic Corporation . . . . . . . . . . . . . . . . . . . . . . . . WEA InternadonalInc.(15) ................................. Warner Music Canada Ltd . ................................ The Columbia House Company (Canada) (partnership) . . . . . . Warner Special Products Inc . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Warner Custom Music Corp . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . WEA Manufacturing Inc . ................................... Allied Record Company . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Time Warner Limited ....................................... Warner Music International Services Ltd . . . . . . . . . . . . . . . . . . . . . Time Warner UK Limited . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Warner Chappell Music Group (UK) Ltd . . . . . . . . . . . . . . . . . . Warner Chappell Music Limited . . . . . . . . . . . . . . . . . . . . . . . . Magnet Music Ltd . . . . . . . . . . . . . . .. . . . . . . . . . . . . . . . . . . Warner Music (U.K.) Limited . . . . . . . .. . . . . . . . . . . . . . . . . . . Ivy Hill Corporation ........................................ T'WI Ventures Ltd . . . . . . . . . . . . . . . . . . . . . . .. . . . . . . . . . . . . . . . . . . American Television and Communications Corporation ("ATC") .... TWI Cable Inc.(17) .......................................... TW/Kblcom Inc.(18) ....................................... lll Perceotage Owned by Immediate Parent 50 100 100 50 (13) 100 100 100 100 100 100 100 100 100 100 100 100 100 100 100 100 100 100 100 50 100 100 100 100 100 50 100 100 100 100 100 100 100 100 100 100 100 100 100 100 (16) 100 100 State or Other Jurisdiction ot Inrnrporation or Organizstion New York Delaware Delaware New I'ork California California Delaware Delaware Delaware Delaware New York Delaware New York Delaware New York Wyoming Delaware California New York Delaware Delaware Delaware Delaware California Delawaze Delaware New York Delaware Canada Canada Delaware California Delaware California U.K. U.K. U.K. U.K. U.K. U.K. U.K. Delaware Delaware Delawaze Delaware Delaware Name KBL Communications, Inc . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Paragon Communications (partnership) . . . . . . . . . . . . . . . . . . . . Summit Cnmmunications Group, Inc . . . . . . . . . . . . . . . . . . . . . . . . . . Summit Cable Inc . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Summit Cable Services of Georgia, Inc . . . . . . . . . . . . . . . . . . . . Summit Cable Services of Forsyth County, Inc . . . . . . . . . . . . . . . . TW/TAE Holding, Inc . . . . . . . . . . . . . . . . . . , . . . . . . . . . . . . . . . . . . . . TW/TAE,Inc . ..... ..................................... Subsidiaries of Time Wamer Entertainment Company, L.P. Time Wamer Entertainment-Advance/Newhouse Partnership . . . . . . . . . CV of Viera Joint Venture (partnership) . . . . . . . . . . . . . . . . . . . . . . . . . Century Venture Corporation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Erie Telecommunications, Inc . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Kansas City Cable Partners . : . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Time Warner Cable New Zealand Holdings Ltd . . . . . . . . . . . . . . . . . . . . . Public Cable Company (partnership) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Queens Inner Unity Cable System . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Comedy Partners, L.P. (partnership) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . CTV Holdings L.L.0 ............................................ CTV HoldingsII L.L.0 . ........................................ Courtroom Television Network LLC . . . . . . . . . . . . . . . . . . . . . . . . . . . . . DC Comics (Partnership) ........................................ Quincy Jones Entertainment Company L.P. (partnership) . . . . . . . . . . . . Warner Cable of Vermont Inc . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . HBO Direct,Inc . .............................................. TWE Asia,Inc ............................................... TWBufferInc . .............................................. Warner Bros. (F.E.) .Inc . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Warner Bros. (Japan) Inc . .................................. Warner Bros. (South) Inc . .................................. Warner Bros. (Transatlantic) Inc . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Bethel Productions Inc . ................................... Warner Films Consolidated Inc . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Exeter Distributing Inc . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Riverside Avenue Distributing Inc . . . . . . . . . . . . . . . . . . . . . . . . . . . HBO Asia Holdings, L.P. (partnership) . . . . . . . . . . . . . . . . . . . . . . . . . . . . HBO Pacific Partners, C.V . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Home Box Office (Singapore) Pty. Ltd . . . . . . . . . . . . . . . . . . . . . . . . Turner/HBO Ltd. Purpose Joint Venture (partnership) . . . . . . . . . . . . . . . Acapulco 37 S.A. de C.V . ....................................... Warner Bros. Gesellschaft mbH . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Time Warner Entertainment Limited . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . The Bountiful Company Limited . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Warner Bros. Studio Stores Ltd . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . iv Percentage Owned by immediate Parent 100 100 (19) 100 100 100 100 100 100 64.8 50 50 54.19 50 100 77 66.01 50 100 100 50 50 50 100 100 lU0 100 100 100 100 100 100 100 100 100 100 8333 100 50 100 100 100 50 100 (20) (21) (13) �22) (23) State or Other Jurisdiction of Inrnrporation or Organization Delaware Colorado Delaware Delaware Delaware Delaware Delawaze Delaware New York Florida Delaware Pennsylvania Colorado New Zealand Maine New York New York Delaware Delaware New York . New York Delaware Delaware Delaware Delawaze Delaware Delaware Delaware Delaware Delaware Delaware Delaware Delaware Delaware Delaware Neth. Antiles Singapore New York Mexico Austria U.K. U:K. U.K. Name Wamer Bros. Consumer Products (UK) Ltd . . . . . . . . . . . . . . . . . . : . . . TWE Finance Limited ........................................ Warner Bros. 'Theatres Ltd . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Warner Bros. Distributors Ltd . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Lorimar Telepictures International Ltd . . . . . . . . . . . . . . . . . . . . . . . . . Warner Bros. International Television Distribution Italia S.p.A. .. Warner Bros. Theatres (U.K.) Limited . . . . . . . . . . . . . . . . . . . . . . . . . . Warner Bros. Theatres Advertising Agency Limited . . . . . . . . . . . . . . Warner Bros. Productions Limited ............................... Warner Home Video (U.K.) Limited . . . . . . . . . . . . . . . . . . . . . . . . . . . . Lorimar Distribution International (Canada) Corp . . . . . . . . . . . . . . . . . . . Lorimar Canada Inc . ........................................... Prodnctions et Editions Cinematographiques Francaises SARL (PECF) Wamer Home Video France S.A . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Time Wamer Entertainment Australia Pty. Ltd . . . . . . . . . . . . . . . . . . . . . Lorimar Telepictures Pty. Limited . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Warner Bros. (Australia) Pty. Ltd . . . . . . . . . . . . . . . . . . .. . . . . . . . . . . Warner Holdings Australia Pty. Limited . . . . . . . . . . . . . . . . . . . . . . . . . . Warner Bros. Properties (Australia) Pty. Ltd . . . . . . . . . . . . . . . . . . . Warner Bros. Theatres (Australia) Pty. Limited . . . . . . . . . . . . . . . . . Warner World Australia Pty. Limited . . . . . . . . . . . . . . . . . . . . . . . . . . Movie World Enterprises Partnership (partnership) . . . . . . . . . . . . Warner Home Video Pty. Limited . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Warner Bros. Video Pty. Ltd . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Wamer Sea World Aviadon Pty. Ltd . . . . . . . . . . . . . . . . . . . . . . . . . . Sea World Aviation Partnership (partnership) . . . . . . . . . . . . . . . . . Warner Sea World Investmen�s Pty. Limited . . . . . . . . . . . . . . . . . . . . Sari Lodge Pty. Limited . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Sea World Management Pty. Ltd . . . . . . . . . . . . . . . . . . . . . . . . . . . Warner Sea World Operations Pty. Ltd . . . . . . . . . . . . . . . . . . . . . . . . Sea World Enterprises Partnership (partnership) . . . . . . . . . . . . . . Warner Sea World Units Pty. Ltd . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Time Warner Germany Holding GmbH . . . . . . . . . . . . . . . . . . . . . . . . . . . . Time Warner Entertainment Germany GmbH . . . . . . . . . . . . . . : . . . . . Time Warner Entertainment Germany GmbH and Co. Medienvertrieb OHG ...................................... Warner Bros. Movie World GmbH & Co. KG . . . . . . . . . . . . . . . . Wamer Bros. Deutschland Pay TV GmbH . . . . . . . . . . . . . . . . . . . . . Warner Home Video GmbH . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Warner Home Video Spol SRO . . . . . . . . . . . . . . . . . . . . . . . . . . . . . GWHS Grundstrucks Verwaltungs GmbH . . . . . . . . . . . . . . . . . . . . . . Warner Bros. Film GmbH . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Warner Bros. Film GmbH Kinobetriebe . . . . . . . . . . . . . . . . . . . . . . Warner Bros. Film GmbH Multiplex Cinemas Mulheim ........ Time Wamer Merchandising Canada Inc . . . . . . . . . . . . . . . . . . . . . . . . . . . Warner Bros. Canada Inc . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . v Peroentage Owaed by Immediate Pareat 100 100 100 100 100 100 100 100 100 100 100 100 100 100 100 100 100 100 100 100 100 50 100 100 100 50 100 SU 100 100 50 100 100 (24) 100 100 (25) 60 100 100 100 100 100 100 100 100 100 State or Other Jurisdiction of Incorporation or O�ganization U.K. U:K. U.K. U.K. U.K. Italy U.K. U.K. U.K. U:K. Canada Canada France France Australia Australia Australia Australia Australia Australia Australia Australia Australia Australia Australia Australia Australia Australia Australia Australia Australia Australia Germany Germany Germany Germany Germany Germany Czech Republic Germany Germany Germany Germany Canada Canada Name Percentage State or Other Owned by Jurisdiction of immediate Incorporation or Parent Organization Warner Bros. Distributing (Canada) Limited . . . . . . . . . . . . . . . . . . . . . . . 100 Canada Warner Home Video (Canada) Ltd . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 100 Canada Warner Bros. (Africa) (Pty) Ltd . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 100 So. Africa Warner Bros. Belgium SA/NV . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 100 Belgium Warner Bros. (D) A/S . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 100 Denmark Warner & Metronome Films A/S . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 50 Denmark Warner Bros. Theatres Denmark A/S . . . . . . . . . . . . . . . . . . . . . . . . . . . . 100 Denmark Scala Biografome I/S. (partnership) . . . . . . . . . . . . . . . . . . . . . . . . . . . 50 Denmark Dagmar Teatret I/S (partnership) . . . . . . . . . . . . . . . . . . . . . . . . . . . . 50 Denmark Warner Bros. Film Ve Video Sanayi Ve Ticaret A.S . . . . . . . . . . . . . . . . . 100 Turkey Warner Bros. Finland OY . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 100 Finland Warner Bros. (Holland) B.V . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 100 Netherlands Warner Home Video (Nederland) B.V . . . . . . . . . . . . . . . . . . . . . . . . . . 100 Netherlands Warner Bros. T'heatres (Holland) B.V . . . . . . . . . . . . . . . . . . . . . . . . . . . 100 Netherlands Warner Bros. Holdings Sweden AB . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 100 Sweden Wamer Bros. (Sweden) AB . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 100 Sweden Warner Home Video (Sweden) AB . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 100 Sweden Warner Bros. Italia S.p.A . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 100 Italy Warner Entertainment Italia S.r.L . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 100 Italy Warner Bros. (Korea) Inc . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 100 Korea Wamer Bros. (Mexico) S.A . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 100 Mexico VJarner Bros. (N.Z.) Limited . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 100 New Zealand Wamer Home Video (N.Z.) Limited . . . . . . . . . . . . . . . . . . . . . . . . . . . . 100 New Zealand Warner Bros. Norway A/S . . . . . . . . . . . . : . . . . . . . . . . . . . . . . . . . . . . . . . . 100 Norway Warner Bros. Singapore Pte. Ltd . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 100 Singapore Warner Home Video (Ireland) Ltd . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 100 Ireland Wamer Home Video Portugal Lda . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 100 Portugal Warner-Lusomundo Sociedade Iberica de Cinemas Lda . . . . . . . . . . . . . . 50 Portugal Warner Home Video Espanola S.A . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 100 Spain Warner Bros. Consumer Products S.A . . . . . . . . . . . . . . . . . . . . . . . . . . . 100 Spain Warner Mycal Corporation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . , . . . 50 Japan HungarY Holding Co . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 100 (24) Delaware HBO Ceska Republika, S.R.O . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 100 Czech Republic (1) TBS is the General Partner and CNN Investment Company, Inc. is the Limited Partner. (2) TBS owns 69.31% and Casfle Rock Entertainment, Inc. owns 30.69%. (3) Tumer Entertainment Networks, Inc. is the General Partner and TEN Investment Company, Inc. is the Limited Partner. (4) Turner Omni Venture, Inc. owns 75% and ICC Ventures, Inc. owns 25%. (5) The names of five subsidiaries of Time Inc. carrying on the magazine publishing business are omitted. (6) The names of nine subsidiaries of Southern Progress Corporation carrying on the magazine or book publishing business are omitted. (7) The names of 13 subsidiaries of Time Warner Telecom carrying on the same alternate access operations are omitted. (8) Advance/Newhouse Partnership owns 19.16667%, Media One Group, Inc. owns 18.86341% and various subsidiaries of Time Wamer Companies, Inc. own the rest. vi (9) The General Partners of TWE own 87.5% and TW /TAE, Inc. and Time Warner Companies, Inc. each own 6.25°/o as limited partners. (10) TWE owns 99� and TW �ervice Holding II, L.P. owns 1%. (11) TW Service Holding I, L.P. owns 99% and TW Service Holding II, L.P. owns 1%. (12) Time Warner Companies, Inc. owns 80% and Warner Communications Inc. owns 20%. (13) Warner Communications Inc. owns 50°!o and TWE owns 50%. (14) The names of 16 subsidiaries of New Chappell Inc. carrying on substantially the same music publishing operations in foreign countries are omitted. (15) The names of 34 subsidiaries of WEA International Inc. carrying on substantially the same record, tape and video cassette distribution operations in foreign countries are omitted. (16) Time Warner Companies, Inc. owns 92.20%, and Warner Communications Inc. owns 7.8%. (17) The names of 42 subsidiaries of TWI Cable Inc. carrying on the cable television business are omitted. (18) The names of 21 subsidiaries of TW/Kblcom Inc. canying on the cable television business are omitted. (19) KBL Communicarions Inc. owns 53.69�'0 of Paragon Communications, ATC owns .74% and the remaining 45.57% is owned by TWI Cable Inc. through its subsidiaries. (20) TWE owns 99% and Time Warner Companies, Inc. owns 196. (21) CTV Holdings L.L.C. owns 33�3'0 & CTV Holdings II L.L.C. owns 16�%. (22) TWE owns 99°7o and TWE Asia lnc. owns 1%. (23) TWE owns 50°lo and TBS owns 50%. (24) TWE owns 99% and HBO Direct, Inc. owns 19'0. (25) Time Warner Entertainment Germany GmbH owns 8590 and Time Warner Germany Holding GmbH owns 15%. vii EI�HIBIT 23 CONSENT OF INDEPENDENT ACCOUNTANTS We consent to the incorporation by reference of our reports dated February 3, 1999, with respect to the (a) consolidated financial statements, schedule and supplementary information of Time Warner Inc. and (b) consolidated financial statements and schedule of Time Warner Entertainment Company, L.P. included in this Annual Report on Form 10-K for the year ended December 31, 1998, in each of the following: i. Registration Statement No. 333-11471 on Form S-4 of Time Warner Inc. (formerly named TW Inc.); 2. Post-Effective Amendment No. I to Registration Statement No. 333-11471 on Form S-4 filed on Form S-8 and related prospectuses of Time Warner Inc.; 3. Post-Effective Amendment No. 2 to Registration Statement No. 333-11471 on Form S-4 filed on Form S-8 and related prospectus of Time Warner Inc.; 4. Post-Effective Amendment No. 3 to Registration Statement No. 333-11471 on Form S-4 filed on Form S-8 and related prospectus of Time Warner Inc.; 5. Post-Effective Amendment No. 4 to Registration Statement No. 333-11471 on Form S-4 filed on Form S-8 and related prospectus of Time Warner Inc.; 6. Post-Effective Amendment No. 5 to Registration Statement No. 333-11471 on Form S-4 filed on Form S-8 and related prospectuses of Time Wamer Inc.; 7. Post-Effective Amendment No. 1 to Registration Statement No. 333-14053 on Form S-8 and related prospectus of Time Wamer Inc.; 8. Registration Statement No. 333-14611 on Form S-3 of Time Warner Inc.; 9. Registration Statement No. 333-27265 on Form S-8 and related prospectus of Time Warner Inc.; 10. Registration Statement No. 333-39647 on Form S-3 of Time Warner Inc.; 11. Registration Statement No. 333=49139 on Form S-8 and related prospectus of Time Warner Inc.; 12. Registration Statement No. 333-61207 on Form S-3 of Time Warner Inc: (and Turner Broadcast- ing System, Inc. and Time Wamer Companies, Inc.) (prospectus also relates to and constitutes a post-effective amendment to Registrarion Statement No. 333-44255); 13. Registration Statement No. 333-69161 on Form S-8 and related prospectus of Time Warner Inc.; 14. Registration Statement No. 33-61497 on Form S-8 and related prospectus of Time Warner Companies, Inc.; and 15. Registration Statement No. 333-37827 on Form S-3 of Time Warner Inc. (and Registration Statement No. 333-37827-01 of Time Warner Companies, Inc.) (prospectus .also relates to and constitutes a post-effective amendment to Registration Statement No. 333-32813). ERNST & YOUNG LLP New York, New York March 25, 1999 EXHIBIT 9 Time Warner Cable is the cable management arm of Time Warner Inc., and will continue as such for AOL Time Warner Inc. As more fully described in Exhibit 8, Time Warner Inc. SEC Form 10-K for the fiscal year ended December 31, 1998 at I-3-4, I-22-32, Time Warner Cable and its affiliates own or manage cable systems serving a total of approximately 12.6 million cable subscribers, geographically concentrated in 35 groupings of more than 100,000 subscribers each. Time Warner Cable is one of the largest and most experienced multiple system cable operators in the United States. Through a network of coaxial and fiber-optic cables, Time Warner's cable television system subscribers generally receive 70 or more channels of video programming, including local broadcast television signals, locally produced or originated video programming, distant broadcast television signals, advertiser-supported video programming (such as ESPN and CNN) and premium programming services (such as HBO, Cinemax, Showtime and The Movie Channel). In some systems, Time Warner also offers audio and other entertainment and information services. Time Warner's record in developing technology to expand the entertainment, information and communications options available on its cable systems is unsurpassed in the industry. The significant achievements of Time Warner's highly regarded staffin areas oftechnical quality and innovation have been widely recognized and have been the basis for numerous awards. Time Warner is committed to giving its customers not only an array of entertainment and information choices but also high quality customer service. Time Warner representatives helped to develop the National Cable Television Association customer service standards and strive to meet and exceed those standards. Though all Time Warner cable systems may draw on the expertise of the Corporate staff, we recognize that providing a quality product and good customer service must be accomplished locally. The subject system will be managed by experienced and qualified personnel at the local level. The office and technical staff who are now responsible for the management and operations of the franchise will continue to operate as heretofore. 113377.1