NEW YORK (CNN/Money) -
Just because you know something is coming doesn't mean it can't hurt you.
Ever since the Washington Post reported last week that AOL Time Warner's America Online division had booked over $270 million in questionable advertising revenues from 2000 to 2002, some investors expected the Securities and Exchange Commission would investigate the matter.
Given that opening a preliminary investigation into media allegations of improper accounting is part of the SEC's modus operandi, AOL's disclosure that it was the subject of a "fact-finding inquiry" was hardly news.
"This was the most anticipated SEC investigation in the history of the free world," said Seth Tobias, of the New York-based hedge fund Circle-T. Tobias said he was long AOL Time Warner (the parent of CNN/Money) and buying more on Thursday.
Still, AOL's stock got rocked. It fell $1.76, or 15 percent, to $9.64. It is down 70 percent this year and 90 percent from its all-time highs.
In many investors' minds the risks of the SEC uncovering anything untoward at AOL far outweighs any potential reward. Hammered by the likes of Enron, WorldCom, Global Crossing and Qwest, they don't want to stick around to learn how the investigation pans out. Furthermore, distrust in companies has reached the point where there's a general view that if you scratch the surface you're almost certain to find something improper.
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"I'm tempted by AOL here, but I don't have it in the fund I manage," said Credit Suisse Asset Management managing director Stanley Nabi. "The risk level is very high."
Indeed, in addition to the SEC investigation, AOL has a host of fundamental problems. Sales at the AOL division have been hurt by the continuing weakness in Internet advertising, and subscriber growth at the unit is slowing. In addition, the company's $28.5 billion debt load is tying its hands in a number of areas, including resolving a conflict with AT&T regarding ownership of several cable properties. Plus, turmoil in the executive ranks (former COO Bob Pittman resigned last week) has contributed to a crisis of confidence on Wall Street.
Analysts were quick to downgrade AOL Thursday morning. Merrill Lynch, Goldman Sachs and Salomon Smith Barney all lowered ratings on the stock.
"[W]hile the investigation may amount to nothing, we encourage investors to sit on the sidelines until the investigation is completed," wrote Merrill's Jessica Reif Cohen, who cut her intermediate rating on AOL to "neutral" from "buy."
The downgrades probably provoked at least some of Thursday's selling, but they also provoked a good deal of chatter on Wall Street that the analysts were being guided more by politics than by fundamental analysis. Many analysts have been caught woefully offside, defending the likes of WorldCom and Tyco as their shares tumbled. In some instances regulators have argued that analysts were guided by their firms' investment banking relationships rather than investor interests. At this point, some say, brokerage firms would rather avoid further criticism.
"The analysts are just sheep and lemmings," said Jeff Bronchick, chief investment officer at Reed, Conner & Birdwell. "When you recommend a stock at $60 and now it's $10 you're institutionally forced to downgrade."
The Richard Parsons Project
Bronchick said his firm recently bought 4 million shares of AOL as it fell from $16 to $11. In the past, Bronchick has been highly critical of the company: He dumped a major stake in Time Warner when its merger with AOL was announced in early 2000. By his reckoning, even if you consider the company's Internet unit, America Online, worthless, the company is worth $17 a share. He thinks the company could be worth significantly more if Parsons makes some key changes.
Like many investors, he would like to see America Online spun off from the firm -- not just because the "synergies" promised by the merger between Time Warner and America Online never materialized, but because many of America Online's potential advertising customers compete directly with Time Warner properties.
"America Online can only prosper if it's the arms dealer," he said. "Time Warner is the enemy to half its customers."
Doug Kass, of the hedge fund SeaBreeze Partners, was one of the most vocal critics of America Online during the go-go years, when he was also betting on the stock's decline. He thinks that the Washington Post's allegations were basically old news.
"I don't think there's much there there," said Kass. He was impressed that the company apparently went to the SEC before the Post article went to press, and that it had its accountant, Ernst & Young, take a second look at the questioned transactions. Kass had reversed his short position and began buying the stock earlier this year.
Still, there's potential for AOL shares to fall even further. It's not just the SEC investigation, said Bronchick, it's that many of the institutional holders of the stock are growth funds, and growth funds are seeing heavy redemptions from investors. Each day they must sell stock to raise cash, and when they pick a stock to sell the one with the accounting questions seems a good choice.
"This is part of a mass liquidation," Bronchick said of the selling. "As a value investor, what we're good at is valuing companies. What we're not good at is figuring out when people will take their foot off the fear accelerator."
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