Why I’ve made a large bet on AOL

I’ve established a large long position in AOL. I believe AOL is an excellent take-out candidate in the current environment, the most likely acquirer being Yahoo. In contrast to the Nokia/Microsoft deal which I wrote about previously, there have been no recent reports in the media of any M&A discussions involving AOL and any other parties, so what follows is speculation from my side based on my analysis of the internet industry, in particular the current competitive environment faced by AOL and Yahoo and my read of which strategic decisions make the most sense for these companies within this environment.

Some important background information on AOL

AOL hit a low of $8.82 in August 2011. Twenty-six months subsequent to hitting bottom, it has risen 343%, including a special dividend of $5.15/share following the sale of a large portion of its patent portfolio to Microsoft. AOL’s market cap currently stands at $2.6 billion, with an estimated EV of around $2.5 billion netting out cash and debt following the recent acquisition of Adapt.tv.

The company’s dial-up business is in a gradual decline, but should bring $600+ million in revenues in 2013, generating annual cash flows of around $500 million. I place a conservative valuation of this business on a wind-down basis at $1 billion. This implies that AOL’s display and search business and other tangible assets are currently being valued at around $1.5 billion by the market.

So what exactly are investors getting for this $1.5 billion today? A modestly-growing internet advertising business that is currently generating around $1.5 billion in annual revenues. Yes, the market is valuing AOL’s search and display advertising business at around 1x current year revenues. This is remarkably cheap in comparison to most other companies in the internet space.  Yelp is around 20x. Facebook around 15x. Obviously AOL isn’t experiencing anywhere near the growth of Yelp or Facebook, but by any metric I can conceive of, AOL’s internet advertising business remains screamingly cheap compared to its peers.

But let’s drill down a bit deeper as to the properties that make up AOL’s advertising revenues. At the end of the day, Marissa Mayer won’t buy AOL because it’s cheap, she will buy it if she feels that she can acquire highly attractive assets that make sense to combine with Yahoo’s operations at the right price.

Key properties in AOL’s “Brand Group” include the Huffington Post (purchased in May 2011 for $315 million), Adap.tv (recently purchased for $415 million), TechCrunch, MapQuest, Patch (its collection of local news websites), and several others, along with related search revenues (a very high margin segment for which Google runs the back-end tech).

Huffington Post is regarded as a top internet news destination. There is little doubt in my mind that the asset would fetch far more than $315 million if it were sold today. The recent purchase of Adap.tv, widely regarded as a shrewd buy by Tim Armstrong, actually catapulted the company to the top spot for online video ad views last month. This is an astounding and important milestone. AOL is actually serving up more video ads right now than the Google/YouTube juggernaut.

Patch has been by far the biggest drag on AOL’s display business financials. Very recently, AOL has begun to scale back its Patch ambitions, reducing related costs. This should have a significantly positive impact on the profitability and cash flows derived from the overall display ad business.

I estimate that the Brand Group is likely to bring in around $800-825 million in revenues in 2013. In addition, AOL has a third-party display ad network (AOL Networks). This is expected to bring in around $675-$700 million in annual revenues in 2013, for a total of around $1.5 billion in revenues from AOL’s advertising business.

The strategic argument: why I think that AOL is a likely near-term takeout candidate

The strong financial reasons why AOL and Yahoo should combine business operations are no secret. Henry Blodget wrote a good piece on this 3 years ago, which remains true today. AOL and Yahoo are very similar businesses. A combination would bring economies of scale in ad sales (leading to higher RPUs) and a reduction in aggregate fixed costs. Simply put, a combination of AOL and Yahoo would likely be a 1+1>2 situation from a revenue and profitability standpoint.

Yet, this has been true for years and obviously a deal hasn’t happened. Why would it now? I believe a number of developments in recent months have increased the likelihood of a Yahoo buyout of AOL in the near-term:

1)      Yahoo has reached a stage where investors are going to start caring again about its core business, and its core business is ugly. Yahoo has risen sharply over the past year despite continued erosion in its core business, thanks to its investments in Alibaba and Yahoo Japan. While the upcoming Alibaba IPO may provide further support, Yahoo cannot expect the same magnitude of share price gains from its Asian assets going forward. This, in turn, will increase pressure on management to improve the core business. Yahoo’s continued dismal revenue performance, on full display in the Q3 conference call, is proof positive that this cannot realistically be done through organic growth alone. So Marissa Mayer will continue to look for acquisitions to grow the business. She will continue to target smallish, cutting-edge companies with top engineers, but these will not move the needle in terms of dramatically increasing scale, revenues and profitability. The only affordable company available to her that would meaningfully move the needle in these areas is AOL. An AOL purchase would instantly increase Yahoo’s revenue by around 45%. Stripping out AOL’s dialup business revenues, Yahoo’s revenues would still increase by around 30%. And in contrast to Yahoo, AOL’s advertising revenues are actually growing. I believe that AOL’s newfound video mojo alone makes AOL a highly appealing target for Yahoo, as this is an area identified by Marissa Mayer and Ken Goldman as a key priority for growing Yahoo going forward.

2)      AOL would provide the biggest bang for the buck in terms of boosting Yahoo’s senior management and salesforce. Marissa Mayer appears to be dissatisfied with COO Henrique de Castro, and reports indicate that he may be out as soon as the end of this year. De Castro is responsible for managing Yahoo’s sales, media, business development and operations. Aside from being an embarrassment to Mayer, who aggressively courted de Castro (and paid a large sum to bring him on), his departure would leave a void. I believe there would be no better solution to fill this void than Tim Armstrong and Arianna Huffington. Yahoo’s sales operations would likely shift to New York under Armstrong. Mayer would have a much stronger sales and operations exec in Armstrong and a much stronger media head in Huffington.

3)      Yahoo and AOL (along with Microsoft) are already working together and recently expanded their partnership. The three companies began cross-selling Tier 2 display ad inventory in 2011 and there have been recent movements by the three companies to automate Tier 1 inventory. This type of partnership makes economic sense and it also ties the companies closer together, increasing the likelihood of an expanded relationship or outright merger.

4)      I think the upcoming Alibaba IPO is a strong potential catalyst for a Yahoo purchase of AOL and that a deal could come in advance of the IPO. In Yahoo’s latest quarterly conference call, the company came out with a surprising revelation that Alibaba had agreed to allow Yahoo to reduce the maximum number of shares Yahoo will be required to sell at the time of the Alibaba IPO. At a $100 billion valuation for Alibaba, the 53.5 million fewer shares sold by Yahoo at the IPO equals around $2.5 billion. I would not be surprised if SoftBank, which owns around one-third of Alibaba may be involved in this, agreeing to sell equivalent shares from their stake. Why? To help fund a cash-rich split purchase of Yahoo’s 35% stake in Yahoo Japan, potentially along with a cash-rich split sale of Yahoo’s Alibaba stake that it will sell at the time of the IPO. Eric Jackson has written extensively about how a cash-rich split could work very well for Yahoo shareholders, and could involve both Alibaba and Yahoo Japan. In this instance, SoftBank/Alibaba would provide cash plus another asset in exchange for Yahoo’s stake in Yahoo Japan/Alibaba. In the event of a cash-rich split, I believe the other asset in question will be AOL.  

What’s the upside if a deal happens and the downside if it doesn’t?

I suspect that a reasonable starting bid for all of AOL would be $4-5 billion, somewhere between a 50-90% premium to the current price. Keeping the dial-up business, Marissa Mayer would be paying $4-5 billion to increase her revenues by 45%, while benefiting from large economies of scale, acquiring key internet advertising assets and bringing on top-notch executives and salespeople. On the other hand, I do not believe that the downside to AOL increases in the absence of a deal – simply because AOL does not currently have a buyout premium attached to it. AOL will rise and fall along with business and market developments and investor attitudes towards the company. From my perspective, it is an inexpensive stock, with valuable, quantifiable assets, a business that has been moving in the right direction, and a good chance at seeing a significant takeout premium in the near-term.

2 responses to “Why I’ve made a large bet on AOL

  1. Pingback: Yahoo and AOL Are Still on a Collision Course | Re/code·

  2. Pingback: Yahoo and AOL Are Still on a Collision Course | News Hub·

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