• by Gavin O'Malley  @mp_gavin, August 2, 2007

Tempering Time Warner's second-quarter earnings on Wednesday, AOL reported the worst sales drop since ditching its subscription model last August. Sales fell 38% to $1.3 billion on the loss of 1.1 million subscribers. But more significant, online ad sales--now AOL's bread-and-butter--missed analyst expectations by as much as 10 percentage points.

Time Warner is "continuing to invest in AOL for long-term growth," defended chairman and CEO Dick Parsons, who noted the unit's "significant programming enhancements" during an earnings call Wednesday.

"All of the changes are aimed at building user-engagement," said Parsons, adding that it will take time for users and advertisers to adjust to recent design changes at AOL.

Ad sales at AOL grew just 16%, or $73 million--way off the 27% gain predicted by Sanford C. Bernstein's leading media analyst Michael Nathanson and the 40% growth rates seen over the last several quarters.

Subscription revenues were down 55%, or $855 million, while operating income was up 9% to $360 million. Advertising on partner sites, primarily through Ad.com, was up 32% in the second quarter.

In another shock to the system, AOL reduced its ad-revenue growth outlook for the second half of the year due to a shift in dollars away from display to third-party remnant ads, according to Wayne Pace, executive vice president and chief financial officer at Time Warner. "We want to be free to make the investments we need," said Pace. "We're not sure we'll stay exactly inside the fence on it," he said, adding: "We don't want to constrain ourselves too much with the guidance."

Parsons defended the move further. "[AOL has] decided they need to make some product improvements," he said. "That creates some short-term turbulence," said Parsons, adding: "That's why we're stepping back.

"This is the first time in five years that we've taken a step back on anything related to guidance," said Parsons, who recently said it will take two more quarters for AOL to turn around.

On average, AOL is now attracting 114 million monthly domestic visitors, and 52 billion domestic page-views monthly. The average AOL user is clocking 152 page-views per month. Email use was up 27% year-over-year, which is far better than the industry average of about 9%, said Jeffrey Bewkes, president and COO of Time Warner.

Still, the company is struggling for ways to further monetize its network.

"As you add behavioral, but not limited to that, it will make our ability to monetize go up," said Bewkes.

AOL agreed last week to buy behavioral ad company Tacoda for $275 million to further improve the monetization of its user base.

AOL is on track to reduce costs by more than $1 billion by the end of the year, according to Bewkes--a key reason for scrapping subscriptions last year.

Overall, Time Warner said second-quarter profit gained 5.2% on higher cable revenue. Net income rose to $1.07 billion from $1 billion year-over-year, while sales rose 6% to $11 billion. The company announced a $5 billion stock buyback.

Saving the quarter for Time Warner, sales at its cable division jumped 59% after CEO Parsons bought assets from Adelphia Communications last year to add customers in Los Angeles and Dallas.

Time Inc.'s profit rose 13% to $256 million. The unit, which holds such iconic titles as Fortune and Sports Illustrated, has cut about 900 jobs over the last two years to boost earnings in the face of slowing print advertising and a shift to digital investment. The Publishing segment saw higher digital ad revenues of $19 million, led by People.com and CNNMoney.com.