Is AOL Back Online?

AOL, Inc. (NYSE:AOL) emerged from its merger with Time Warner (NYSE:TWX) in 2009 and- perhaps surprisingly for a company best known for its leadership position in dial-up service in the 1990s and its made-for-case-studies relationship with Time Warner- has risen 44% since that time with the stock price more than doubling this year. This has been due to two consecutive quarters of good earnings and the company’s sale and licensing of a large portfolio of patents to Microsoft (NASDAQ:MSFT) in June for about $1 billion (for purposes of comparison, AOL’s market capitalization currently stands at just over $3 billion). The proceeds from this patent sale are being returned to shareholders through a series of repurchases.

Jeff Smith

However, AOL’s business is in fact struggling. The company’s second quarter 10-Q reported a decline in revenue compared to the second quarter of 2011, and the same relationship holds for the first half of the year. While advertising revenue is up, subscription revenue is down; it seems likely that the subscription business will continue to decline as dial-up service becomes less competitive. These days, consumers can get faster Internet access on a phone than through PC dialup service. While the company has seen some progress in cost cutting compared to last year, to even tread water going forward AOL, Inc. will have to rely on continued growth in advertising revenue from its content sites. These properties include, for example, the Huffington Post family of sites and Mapquest. The overwhelming majority of AOL’s business continues to come from the United States. AOL Inc. (NYSE:AOL) trades at 27 times forward earnings, likely because investors are excited by the size of AOL’s share buybacks compared to the market capitalization- as noted, the company faces an uphill battle to actually growing its business. The stock trades at book value, which would be expected as such a large share of its assets are cash post-deal.

According to 13F filings for the first quarter of 2012, the largest hedge fund holder of the stock- and, assuming it held onto its shares, the biggest winner from AOL’s rise- was Jeffrey Smith’s Starboard Value with 4.9 million shares. Starboard concentrates on the technology sector and reported AOL as the largest holding in its portfolio. The fund initiated this position in the fourth quarter of 2011 (see other favorite stocks from Starboard Value). Bain Capital’s Brookside Capital initiated a 2.4 million share position in the first three months of 2012 (learn about other stocks owned by Brookside Capital). D.E. Shaw and Renaissance Technologies both had positions at the beginning of the year and added to them in the first quarter, with D.E. Shaw finishing the term with 4.1 million shares and Renaissance Technologies reporting ownership of 1.4 million.

Yahoo (NASDAQ:YHOO), whose new CEO Marissa Mayer is likely still planning how to turn around the business, is AOL’s closest peer as an Internet portal. Yahoo trades at only 14 times forward earnings estimates, though it does not have the power of large buybacks pushing up its stock price. We looked at Yahoo shortly after Mayer was announced as the new CEO. The company’s stock has not done as well as AOL’s recently but is still up about 35% over the last year. Microsoft, mentioned earlier as the acquirer and licenser of AOL’s patents, has a forward P/E of about 9 though some of this may be driven by a bump in expected earnings as the software giant releases new versions of Windows and Office. Finally, Google (NASDAQ:GOOG), the leader in search and many other Internet services, trades at 13 times forward estimates of its earnings. We think that AOL Inc. (NYSE:AOL)’s stock price may well continue its rise in the near future on the strength of its buybacks, but is not a good long-term investment. The advertising business unit may be desirable, but we think that Yahoo or other content providers offer a similar potential upside in that vertical at a better value and without the shrinking subscription business.

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