Description

AOL Inc. is a leading global web services company with an extensive suite of brands and offerings and a substantial worldwide audience.  AOL's business spans online content, products and services that the company offers to consumers, publishers and advertisers.  AOL is focused on attracting and engaging consumers and providing valuable online advertising services on both AOL's owned and operated properties and third-party websites.  In addition, AOL operates one of the largest internet subscription access services in the United States.  AOL generates revenue primarily through 1) Online Advertising; 2) Access Subscriptions; and 3) Other Services.

1)       Online Advertising:  Advertising is AOL's largest business segment, contributing 53% of total revenue in FY10.  The segment is comprised of 3 key offerings: 

• O&O Display Advertising: AOL owns and operates over 90 websites showcasing in-house and licensed content. Examples include AOL, AOL Music, Huffington Post, MapQuest, Stylelist, Engadget, TechCrunch, Moviefone, Games.com, Joystiq, Black Voices, Patch, etc. The company sells display advertising such as banners and rich media ads on the content pages of its owned and operated (O&O) content properties. AOL's strategy is to leverage its direct sales force to sell its premium inventory directly to advertisers and agencies, at premium CPM rates.
• Paid Search: AOL is one of the largest members of Google's AdSense network. Google provides the algorithmic search results as well as the paid search ads to AOL. Advertisers bid for search ads on a cost per click basis on Google's AdWords platform and pay Google only when someone clicks on the search ads shown on AOL's search pages. Google in turn pays AOL roughly 90% of the incoming revenue in the form of TAC (traffic acquisition cost) payments, most of which flows through to AOL's bottom line.
• Advertising.com: Advertising.com is AOL's ad network that connects third-party publishers with interested advertisers. The ad inventory is typically non-guaranteed in nature and sells at a much lower rate compared to premium ads. Most publishers in the network have a revenue sharing agreement with AOL where 80% or more of the segment revenue is funneled back to the publisher in the form of TAC payments.

2)       Access Subscriptions:  This is AOL's legacy business that made AOL a household name in the first place.  As the largest domestic online Subscription provider, AOL leads a small pack of competitors such as EarthLink and United Online.  AOL currently has approximately 3.6m subscribers as of March 31, 2011 with an average tenure in excess of 10 years.  AOL generates revenue by charging its subscribers a monthly fee for providing dial up access and broadband services, including email, security and storage.  AOL's subscription business accounted for 42% of total revenues in FY10.

3)       Other Services:  Other services primarily consist of revenue associated with the licensing of AOL's AdTech platform to large advertisers or ad agencies, to help them manage their online campaigns.  The segment also includes licensing fees for its communication products such as email and IM and some mobile revenue.  Other services accounted for 4.5% of total revenue in FY10.

Investment Thesis

Talented new management team / Turnaround noise largely behind them: 

• After 9 years of low morale and significant mismanagement, in April 2009, Time Warner hired Tim Armstrong to become the new CEO, and since then AOL has been busy re-inventing itself as a leading online media company with a renewed strategy, focus and discipline.
• Tim Armstrong joined AOL from Google, where he oversaw the company's North American and Latin American advertising sales, marketing and operations teams as President of The Americas Operations. He quickly built a very strong bench by recruiting away top talent from Google, Yahoo and even Silver Lake Partners. Despite the rise of sexy web 2.0 startups, Mr. Armstrong has done a good job of retaining his talent, as top executive turnover has been minimal.
• During 2009 and 2010, Tim Armstrong has embarked on a significant restructuring effort, which included selling off non-strategic assets, shutting down unprofitable operations and businesses, exiting unprofitable partnership deals, halting bad monetization practices, etc. This has led to an incredibly messy transition period and noisy financial statements, to say the least, however, the clouds should begin to clear in the back half of 2011 as the comps get cleaner.
• Mr. Armstrong has leveraged his close ties to Google and the advertising community to chart the course of AOL's future strategic direction. As the restructuring noise subsides, the new AOL should be very well positioned to take advantage of the secular growth tailwinds of the online advertising market.

AOL's new strategic direction is specifically aimed at addressing two major hurdles that large branded advertisers are currently grappling with, which should lead to above average growth rates in the future:  

• Advertisers are anxious to spend more money online, particularly on display ads, but have been slow to do so due to two major hurdles: 1) it is difficult for large advertisers to spend money at scale due to the fragmented nature of the Display market; and 2) advertisers are fearful that their brand advertising may end up next to low quality content that cheapens or misrepresents their brand when buying at scale through an ad network.
• AOL is specifically focused on solving this problem via its Project Devil initiative, its focus on premium content production and video, and hyper-targeted content strategy built around vertical (women, technology, music, etc.) and local (Patch) communities.
• AOL's strict focus on creating an optimal premium display ad environment for advertisers will differentiate it's O&O sites and ad network from its competitors, which should translate into above average growth rates in display advertising, which is projected to grow at a 15% CAGR for the next few years.
• The total market opportunity for Display ads should increase meaningfully as these key issues are addressed. Advertisers from major brand-focused verticals such as CPG, Pharma, Entertainment, Travel and Media currently spend less than 10% of their ad budgets on line, creating significant opportunity going forward.

Ample downside protection: 

• While in rapid decline, the Access Subscription business is a cash cow, which we expect to generate over $700m in FCF over the next 4 years, or approximately 40% of AOL's current enterprise value of $1.8b.
• AOL's Online business is currently cash flow negative and is expected to reach breakeven by 4Q11. However, should this not occur, can we make the argument that AOL's Online business is worth at least $1.1b?
• Due to the large amount of overlapping resources of large online content producers salesforce, ad network, content production and G&A) , there are significant cost synergies to a potential consolidator of the industry, such as Yahoo, MSN, Google, Valueclick, or private equity back players such as Atomic Online. For example, AOL was able to add $20m to the Huffington Posts bottom line of $10m by shutting down AOL's overlapping news and finance divisions. We currently estimate that AOL Online division's opex, excluding TAC, is running at $1.3 billion. Conservatively assuming an acquirer could eliminate 20% of the opex, the savings alone would be worth in excess of $1.4b, based on an 11% cap rate.
• AOL is currently absorbing $140m in annual run rate operating expenses as it rolls out its hyper-local initiative called Patch. Should this initiative not work out, we estimate shutting Patch down would be worth over $700m, assuming $80m in severance payments and an 11% cap rate.
• In a worst case scenario, AOL has several levers to pull, including returning to aggressively monetize its audience of 112m monthly unique visitors and engaging in search word arbitrage, similar to that of IACI, which generates over $150m in EBITDA on much less traffic.
• AOL also has a tax basis in Netscape of $2.5b which may be valuable to a potential acquirer.

Acquisition of Huffington Post and TechCrunch will reinvigorate growth and engagement within the old AOL network and vice versa: 

• Due to the network effect created by cross linking sites within the AOL family, the addition of two fast growing and influential sites will help invigorate growth and engagement across all of AOL's properties. This network effect will also benefit the growth and engagement of Huffington Post and TechCrunch users. After being plugged into the AOL network, TechCrunch grew new users by over 60%.
• Huffington Post's political relevance positions it well to benefit from 2012's election year. AOL will also benefit from the free national media exposure generated through Ariana Huffington's many appearances on TV.
• In addition to the Huffington Post, AOL also picked up a state of the art technology platform, with tight integration into the social media world, and a self-policing commentary platform that drives high levels of relevance and engagement. AOL has the opportunity to rolls this unique platform out to its network of content properties, which should drive higher user engagement and awareness.

Key Value Drivers 

• Increase in monthly unique visitors
• Project Devil engagement metrics and CPM lift vs. traditional display
• Display ad growth rate
• Market share gains in Display
• Continued shift of ad spending to the online
• Growth in revenue per search
• Reduce churn in access subscription business

Warranted Value 

• BASE CASE = $29 (based on 11% FCF yield on FY14 estimates, assumes no incremental revenue benefit from Patch and full absorption of $140m per year burn rate)
• DOWNSIDE = $16 (based on SOTP, harvest cash flows from run off of Subscription business by 2016 w/ 30% haircut from base case, and 13% FCF yield on FY14 estimates for Online business assuming 30% haircut to base case).

WATERFALL ANALYSIS

Catalyst