AOL: You've Got Value

One of the most anticipated spin-offs of the year is finally upon us, as AOL  is once again a stand-alone company. While we recognize that the firm is not without its issues, including declining users and a weaker brand, we think it should trade at $29 per share, a roughly 26% premium to the current share price of around $23. Here is Morningstar equity analyst Larry Witt's thesis on AOL:

"By focusing on the average person (as opposed to the technical community), AOL provided a more user-friendly experience than its peers, allowing its popularity to explode along with the Internet. In 2002, the company had 26 million U.S. subscribers (35 million globally) and $9 billion in revenue. However, technological innovation changed the game, as the availability of high-speed Internet connections became ubiquitous. AOL's subscriber base has declined significantly (just 5.4 million as of September 2009), a trend we expect to continue.

Realizing the dial-up business was in decline, in 2006 the company decided to allow anybody with an Internet connection to access AOL's content (before then, AOL's content was available exclusively to AOL subscribers). The goal was to increase the size of AOL's audience and focus on advertising to drive revenue growth. Initially, this led to solid increases in AOL's audience and advertising revenue. However, we think both of these metrics may have peaked, as AOL's audience has started to decline. We think the continued loss of dial-up subscribers and the fragmentation of online audiences will prevent AOL from expanding its audience. Additionally, marketers can use ad networks and ad exchanges to reach their desired audience (mass or targeted niche) at a lower cost. We think the combination of a shrinking audience and alternative options for marketers will make it more difficult for AOL to attract advertising dollars.

The continued loss of AOL's audience should result in fewer search queries and thus lower search revenue as well. In addition, we think AOL received a very lucrative revenue share split from  Google (GOOG) in 2006 (Google powers AOL's search offering). At the time, Google's market share in search was only about 45% (it's at about 65% today), so the company was more willing to pay up for distribution deals. We think Google will be more prudent when signing deals in the future; the current search deal between AOL and Google expires in December 2010.

Given its tarnished brand, we doubt AOL will be able to reinvent itself. Therefore, we think most of AOL's core segments (dial-up, search, and premium display advertising) will face head winds and revenue declines over the next five years. Although we think the company will continue to rightsize its cost structure, some of its costs are fixed. Therefore, we expect operating margins to decline as well."

Larry's fair value of $29 per share assumes declining overall growth, due to lower subscription revenue and flat advertising sales, as he explains below:

"Our valuation implies forward fiscal 2010 price/earnings, price/free cash flow, and enterprise value/EBITDA multiples of 8, 10, and 4, respectively. Although these valuation metrics appear low, we think they are appropriate considering our expectations for cash flows. Declines in dial-up subscribers will be the main drag on growth, as we forecast subscription revenue to decline an average of 24% over the next five years. On the other hand, we expect AOL's advertising revenue to remain relatively flat (after a steep decline in 2009) as secular tail winds in online advertising are offset by a declining user base. Overall, we expect revenue declines to average 11% through 2013. We estimate that AOL's dial-up business generates the vast majority of the company's profits. Therefore, we expect lower profitability as the dial-up business declines. We forecast the operating margin to decline to 10% in 2013 compared with 26% in 2008 (excluding one time charges). Lower profitability should also lower returns on invested capital, which we expect to fall below our cost of capital assumption within a few years."