(FORTUNE Magazine) – Steve Case, the chairman of AOL Time Warner, the world's largest media company, walks over to the conference table in his sun-drenched office in Dulles, Va., and unscrews the cap of a bottle of water with the AOL logo on its label.

"This is our new strategy," he declares, setting it on the table. "AOL Water." He waits a beat. "Hey, if Vivendi can do it..."

That's a joke, but it's a telling one. As if AOL Time Warner did not have enough problems, critics now say it has no reason to exist. Break it up, is the outcry. They say the last big deal of the dot-com boom, which married AOL and Time Warner, is no longer logical, if it ever was. You remember what Case and Time Warner's Jerry Levin had in mind, don't you? They promised a convergence of the TV and the PC, of new and old media, of television, music, magazines, and movies, all of which would be reconfigured into bits, to be distributed and cross-promoted and sold by the world's first Internet-powered media company.

So now what, Steve? Seen any good movies on your computer lately? What's your strategy, besides water? Does this company make any sense?

"Sure, it makes sense," Case says, in his usual low-key manner. "It's been a difficult year on many fronts, obviously. But the strategic logic of the merger is just as true today as it was two years ago. In some respects, more true.

"That's not to say that where we're sitting today, everything is wonderful. We have challenges. We have issues. People are skeptical. Cynical. Anxiety's high. The stock price is low. We understand that. We're not in la-la land.

"But this is not the first time our company has experienced a challenge like this. What I've found is that through those challenges, even crises, our best work gets done...and I'm confident that AOL Time Warner, even though there have been missteps in the first year, is on a path to emerge as one of the truly great companies in the world."

Yes, he's sticking with his story--and we'll let him explain why in a moment. FORTUNE went to visit Case because, after lying low for a while, he's once more fully engaged by AOL Time Warner, even as Dick Parsons prepares to take over from Levin this month as CEO and Bob Pittman tackles the unexpected problems at America Online. Their roles are more or less clear. Parsons, 54, has a big to-do list: He must drive up cash earnings (and not merely the justly maligned Ebitda), simplify the company structure, and regain Wall Street's trust. Pittman, 48, has to reverse the plunge in advertising at AOL, which is in worse shape than most people thought. And Case, 43, who likes to ponder the world with a five-to ten-year horizon in mind, has to rethink and refine the vision.

Still settled in suburban Virginia near AOL offices--corporate headquarters are in New York City--Case makes clear that he isn't running AOL Time Warner, which owns the Warner Bros. TV and movie studios, cable systems, cable networks such as HBO, TNT, and CNN, and magazines including Time, People, and the one you're reading. He's not the man to see if you're looking for operational or financial detail. And he was all but invisible during the company's first year. That was partly so he could spend time with his gravely ill brother, Dan, but mostly, he says, to give Levin space to operate as CEO.

So Case watched from the sidelines as AOL Time Warner took a beating. The dot-com bubble burst. The advertising economy crashed. "What went wrong with this merger?" asks an exasperated AOL insider. "It's the economy, stupid." Then the collapse of Enron put a hex on companies with complex accounting. This was not the kind of convergence that Case and Levin had in mind.

To be sure, many of the problems that have beset AOL Time Warner are beyond its control. And by some measures the company has performed better than its competitors during the media industry slowdown. AOL Time Warner's revenues and operating income have grown in each of the past five quarters. No other entertainment giant--not Viacom or Disney or News Corp.--can say that.

On the other hand, none of the other media behemoths has seen its stock price crumble the way AOL Time Warner's has. Shares have fallen 60% since the merger was consummated in January 2001, wiping out more than $117 billion of shareholder value--roughly equivalent to the market caps of News Corp. and Viacom combined. There are a number of reasons for this. The company was wildly overvalued and grossly overhyped, and top executives seemed to believe their own PR even as saner voices grew skeptical. First they projected growth of 25% annually in Ebitda, the company's preferred measure of earnings; then they forecast double-digit growth; now they're talking about 5% to 9% growth for 2002. (Dick Parsons says there'll be no more overpromising; see box.) More recently the stock has been punished because investors are focusing on all the problems at the AOL unit.

But the biggest cloud over the company and the stock is that AOL Time Warner doesn't seem to have made much progress in fulfilling the promise of the merger. Some investors have come to view the stock as little more than an agglomeration of entertainment, cable, and Internet properties that has underperformed "pure play" rivals in each of those sectors. AOL Time Warner shares have been outperformed in the past 12 months not just by entertainment rivals but by cable operators such as Comcast and Cox, and even by Internet players Yahoo and EarthLink. Put another way, investors who figure advertising will rebound can buy Viacom; those looking to bet on broadband might invest in Comcast; and Internet true believers have eBay.

The curious thing is, AOL Time Warner is in fundamentally better shape than many of its rivals. Most of its seven divisions are clicking: Warner Bros. has created movie franchises with Harry Potter and Lord of the Rings that will generate revenues for years to come. The cable systems are rolling out digital services, including video on demand, that drove double-digit increases in revenues and cash flow in the first quarter. While the Turner cable networks are struggling, HBO has captured the creative high ground in television and, as a pay service, is shielded from the ad slump. Time Inc.'s magazines, after acquiring a big European publisher, grew cash flow by 14%. And even the music business, whose future is uncertain, has eked out revenue and cash-flow gains.

The AOL unit, though, is capturing the bulk of the attention, not just from analysts and the press but from top management. Its advertising and commerce revenues fell by 31% in the first quarter, as lucrative, long-term deals made at the peak of the dot-com nuttiness expired. Case says some of its products, like AOL TV and a wireless messaging device, weren't very good, and the unit "lost a little of its focus on the member." Shuttling between New York and Dulles, Pittman's supposed to engineer a turnaround while still functioning as chief operating officer of AOL Time Warner. And Parsons has to soothe embittered Time Warner executives who think AOL is ruining their company.

So why not break up AOL Time Warner or spin off the AOL unit, as some frustrated investors have suggested? "It strikes me as silly," says Case. His view, in brief, is that the Internet remains a very, very big deal, and that AOL Time Warner is uniquely positioned to capitalize on it. "If you take a step back and think of it as a movie, not just a freeze frame, I think the trends are clear," he says. More people are using the Internet for more hours. They are listening to music on their PCs. They are sending instant messages over cellphones. Sure, he says, Wall Street valuations have come down, but "the Internet phenomenon, the trend toward more of a connected society, is unabated. The momentum is very strong."

As consumers use the Internet in new ways, on new devices, to do new things, "they rely on a company like AOL Time Warner to connect the dots for them," Case says. The same goes for advertisers, which want to market and sell products and develop deeper relationships with customers.

Fair enough. And what, specifically, is the company doing to connect the dots? "We've identified a number of [intercompany initiatives], none of which I'm going to tell you about right now," Case says.

That's a problem. Investors have been waiting for a long time to see what kinds of new businesses convergence can produce. As Sanford Bernstein analyst Tom Wolzien puts it, "Great Time Warner content is being squandered by the combined companies."

So far AOL Time Warner has found synergies mainly in cross-promoting movies, magazines, TV shows, and the like. Last year the company was its own biggest advertiser. But, as Case himself concedes, "the merger was never about cross-divisional promotion. It was about cross-divisional innovation."

One idea being mulled over at corporate strategy sessions is to deploy Time Warner content to set AOL apart from other online services, particularly over broadband connections. This might mean creating ad-sponsored AOL "sneak previews," for instance, giving AOL members a track from a new Linkin Park CD or five minutes from a Harry Potter film before it hits theaters.

So what's the holdup? After all, this was exactly the kind of service Case was envisioning even before the merger. "We're beginning to see the first glimmers of convergence, and that will pick up steam over the next decade," Case says. "I've always said this is a marathon, not a sprint." For the past year or so, AOL Time Warner executives have been busy integrating the merged companies and cutting costs. And 2002 looks to be another transition year, as the team in New York deals with pressing issues such as simplifying AOL Time Warner's corporate structure, clearing up concerns about the company's balance sheet, and boosting the stock's esteem in the eyes of shareholders.

The real promise of digital convergence, of course, lies in broadband, and here AOL Time Warner has a lot to prove. "On the AOL side, we haven't executed all that well in broadband," Case says bluntly.

To deliver the rich services at the heart of convergence, AOL needs to upgrade its nationwide pool of dial-up customers to broadband--not an easy proposition when the company's cable lines reach into only 20% of American homes. To reach the homes that Time Warner cable doesn't serve, AOL has to strike complex deals with phone companies and cable operators, usually involving revenue sharing or finder's fees. "It took us longer to get deals with cable companies and [telcos] than I might have expected," Case concedes.

AOL provides broadband directly to some 500,000 users, a scant 5% of high-speed Internet users, analysts say. Another 2.5 million AOL users get their broadband from someone else--their cable operator or their phone company--yet AOL says most continue to pay full price for an AOL account, essentially double paying, so that they may continue to access AOL outside the home, say in a hotel room. But that arrangement leaves AOL sharing the consumer with the hard-wired broadband provider, which undoubtedly has convergence fantasies of its own. Comcast, for example, aspires to sell phone service and movies on demand to its broadband customers. "AOL's customers are ripe for the picking," says Deborah Lathen, a consultant and former head of the Federal Communications Commission's cable bureau.

Case doesn't show it, but his return to a day-to-day role at the company suggests he feels a sense of urgency about the company's strategy. He has good reason: AOL Time Warner has its share of unpredictable gadflies. Ted Turner, wooed by Parsons into remaining at AOL Time Warner after a falling-out with Levin, has been unusually quiet in recent months--but chances are he won't be for long if the value of his 3.6% stake in the company continues to plummet. The always inscrutable cable magnate John Malone, whose Liberty Media holds a comparable chunk of AOL stock, also seems to be agitating for change: He's seeking to alter rules that limit his stake--and his voting rights in the company--sparking rumors that Malone is interested in a seat on the board.

With Malone, a master of financial engineering, back in the picture, all options are on the table. Case isn't about to join in the speculation about his company. But given the pressures from Wall Street, as well as the headache of corporate partnerships that both Case and Parsons want to unravel and a heavy debt load, the company is likely to look quite different by this time next year. One option: spinning off not AOL but cable systems, perhaps in combination with another cable operator such as Adelphia or Cablevision, creating a new company in which AOL Time Warner would own a stake. Another idea: a new company combining NBC with Warner Bros. and the Turner networks, merging MSNBC into CNN, and CNNfn into CNBC. If that sounds farfetched, who would have thought 15 months ago that Time Warner would grow faster than AOL, Parsons would replace Levin, and Pittman would return to suburban Virginia?

The one thing that isn't likely to change is Case's vision of the future. Sipping at his bottle of AOL-branded water, he says, "We are still moving toward a more connected society. That's the real story, if you for just a minute didn't look at the Bloomberg ticker and just watched what people are doing in their everyday lives."

Maybe he's right, and society is becoming increasingly connected. The trouble is that AOL Time Warner is not. Until that changes, it's unlikely that investors will be rewarded by this merger, or that Steve Case's vision will come to pass.

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