Description

Investment Thesis:

I recommend a long position in AOL and accumulating the shares in the mid-$20s.  Using a conservative sum of the parts analysis and assuming there is no value in the existing AOL Media business, there is downside to $19.68.  Making reasonable assumptions for the stabilization of the Media business, I think there is upside to $48.42.  As I think the likelihood of the Media business being worth 0 is very low, there is a greater likelihood of $48.09 than $19.68.  

Business Description:

AOL's business can be divided into 6 sub-segments: 1. dial-up internet access business, which is secularly declining, 2. communications tools such as AOL Mail and AOL Instant Messenger (AIM), 3. content sites, including the AOL.com homepage and Moviefone, 4. third-party network sites through which AOL sells and serves ads, 5. local search, content, and mapping sites such as MapQuest and Patch.com,  and 6. AOL Ventures, comprising assets AOL plans to divest, such as Bebo. 

Investment Opportunity:

AOL is an interesting investment opportunity because the company and stock are out of favor.  The general perception of AOL as a broken asset stems from years of underperformance as part of its parent company, Time Warner (TWX).  Finally, investors assume that the new management's initiatives in local (via Patch.com) and content (via seed.com) will not succeed.  As a result, investors get this option for free.   

Investment Risks:

1. Dial-up access is a declining business.  Subscriber counts have fallen close to 30% YoY for 14 consecutive quarters.  ARPU is falling.  In addition, dial-up is extremely profitable, with an estimated 75% EBITDA margin and the vast majority of AOL profits on an annual basis.    
2. Traffic to AOL's core assets (AOL.com, AOL search) is in decline.  Usage of the site is falling because dial-up customers are the heaviest users of the AOL site.    
3. Due to usage declines, paid search revenues fell 19.1% YoY in Q409 and display advertising fell 17.2% in 2009 (but only 2.6% in Q409). 
4. AOL's search contract with Google expires at the end of 2010.  Currently, AOL generates 18% of revenue from this relationship.  The economics of a new deal will likely be less attractive to AOL and this revenue comes at a ~90% EBITDA margin. 
5. AOL management, even if it sells the aforementioned assets, may chose to spend the cash in ways that are not friendly to shareholders, such as expensive acquisitions or increased operating costs, rather than buybacks/dividends. 

Investment Merits:

1.        Assuming AOL's Media business is also in secular decline, the value of the business should be determined by the cash flows of the dial-up access business and the sale values of all other assets. Below is the summary of potential proceeds from asset sales, which forms the basis of my downside scenario.  

Of note, MapQuest could attract a significantly higher valuation if it were to be sold to a strategic buyer, namely Microsoft or Apple.  MapQuest is the #2 mapping business on the internet with 38.5mm monthly unique users (Google Maps' 52.4mm).  Both Microsoft and Apple are looking to displace Google's dominance in local/mapping. 

2.        Assuming AOL divests the aforementioned assets, the company is left with a declining advertising business consisting of three parts: search, display, and partner-site advertising.  Since the primary reason for the decline in page views is the drop in access customers, I have decided to eliminate 40% of page views/revenues from this segment in order to achieve a worst case, albeit stable, scenario.   In addition, I consider two cases for EBITDA margins.  First, AOL achieves 35% EBITDA margins, which is on par with Yahoo's current EBITDA; AOL management says this is attainable.  Second, I assume an 18.5% margin, or the midpoint between AOL's current 2% margin and Yahoo's 35% margin. 

After eliminating the dial up subscribers, it isn't unreasonable to think that the core revenue base will grow.  In fact, recent results aren't as bad as they seem:

a.        AOL display advertising improved from down 18.1% yoy Q309 to down 2.6% in Q409.

b.       AOL revenues have not dramatically underperformed YHOO revenues, while YHOO page views have grown.

c.        AOL asserts previous management intentionally reduced prices for premium inventory. 

d.       New efforts to produce original content, improve product functionality and optimize pages for search engines could drive new users/page views

3.        At a $25.70, investors are not baking in a turnaround.  A few reasons exist to think this is possible: 

a.        New CEO Tim Armstrong understood the asset he took over.  The fact that he chose to join AOL may be an indication that he thinks it can be saved.  As president of Google's Americas operations, he signed the 2005 contract with AOL and had access to their performance data.    

b.       AOL has two core assets that differentiate it from the competition and could position it to succeed with its new content-driven model. 

i.      AOL can use search data as well as trends from its partner-site network to identify emerging news stories to write about

                ii.      AOL's sales force and its Google contract provide the company with a monetization advantage that will allow it to pay partners/writers more than other sites 

c.        Tim Armstrong's financial incentives seem to be relatively well aligned with shareholders. 

                i.      He exchanged his unvested Google stock for $20mm of AOL shares and options that vest over a 2-year period

                ii.      He is set to receive 1.5% of the aggregate value of the company in options on the date of the spin-off, at the spin-off valuation.  

Valuation Matrix and recommendation

At $25.70, AOL has downside to $19.46 and upside to $48.42 and a risk/reward of 4:1. 

Catalyst

1. Sale of assets (land, ICQ, Mapquest) 

2. Slower declines in display or access businesses