Jul 25, 2009

AOL - R.I.P.?

(updated July 30 to include note 2.)

Saul Hansell has put together an illuminating timeline of AOL's sad decline over the past decade at his New York Times blog.

As Tim Armstrong, who recently took the helm at AOL, attempts to revive the company, I am reminded of one of Warren Buffet's most popular aphorisms: "When a management with a reputation for brilliance tackles a business with a reputation for bad economics, it is usually the reputation of the business that remains intact."

To be fair, AOL is not completely dead yet. According to press reports, the company was valued at around $5 billion based on Time-Warner's recent buyback of Google's 5% interest in AOL, but the real valuation is likely half to two-thirds that much (see notes 1 and 2). In the quarter ended June 30, 2009 AOL reported operating income of $271 million on revenue of $804 million (see page 19 of filing). At quarter's end, AOL still counted 5.8 million paying subscribers for internet access, but lost 500,000 subs in the quarter. At it's peak, AOL claimed 27 million subs and was the world's most visited website. Today, acording to Alexa, is the 35th most popular site, only two places behind Google's Italian search site and a distant 33 places behind Yahoo. So if AOL is not quite dead, it does look a bit like the guy over John Cleese's shoulder in this classic Monty Python bit.

I have been an AOL skeptic for a long time, going back to the mid- to late-1990's when it's widely publicized service failures gave rise to nicknames like "America Off-line" and "America On Hold".

My skepticism was primarily related to the "walled garden" approach to the internet that made up AOL's content offering. While this "internet-on-training-wheels" offering clearly worked for internet novices, it always seemed fundamentally disadvantaged to me. It just seemed unlikely that a single company could pay its employees and moderators to "summarize the internet" when the internet itself was available for free. And over time, new and improved (and free) internet browsers and portals like Yahoo (also free) and search engines like Google (again, free) made the internet easily navigable, rendering AOL's walled garden of content embarassingly superfluous. At bottom, I always saw AOL as a dial-up internet service provider whose attempts to become a content company were doomed by an infinitely more powerful force that, ironically, AOL itself helped enable.

And writing this in 2009, I feel reasonably sure that my decade-old instincts were correct in the long run.

But there was a period, let's call it 1997 through 1999, during which I was spectacularly wrong about AOL (or at least about it's stock price) and I am grateful for my employer's compliance restrictions that prevented me from shorting the stock.

The AOL saga illustrates some classic themes for technology and growth stock investors.

1) In the long-run, technology matters... a lot. Ultimately, AOL's core business was dial-up internet access. Its inability or failure to develop a competitive broadband offering was an obvious and fundamental weakness that eventually and inevitably eroded its subscriber base. And as I mentioned above, the attempt to develop a content offering to offset that risk faced a powerful, if not invincible force.

2) In the short run, don't underestimate inertia. AOL's subscription model, based on relatively modest charges to a subscriber's credit card, worked for a long time even after broadband internet service became widely available in the U.S. I suspect many subscribers carried the service for several months longer than they needed it because it required a proactive decision (and a not-insignificant investment of time) to cancel the service. True, AOL's customer service operations and policies seemed designed to make it inconvenient, if not downright impossible to quit, a practice for which the company has been widely criticized. Even today, some subscribers are unwilling to part with a long-standing email address, creating some stickiness in the subscriber base. There was also a time -- which seems almost quaint in the Twitter age -- that one's AOL Instant Messenger buddy list was considered a significant barrier to switching.

3) Sometimes, widespread customer service "failure" is really evidence of overwhelming customer demand, hence a bullish signal. When AOL switched from metered billing to flat-rate billing for internet access, it triggered a huge increase in subscribers and usage. AOL's inability to keep up with the demand surge led to its widely publicized service outages. From an investment perspective, this was actually positive, at least in the short run. Indeed, the surge in subscription revenue allowed AOL to quickly invest in the infrastructure to meet the increased demand. To be clear, widespread customer service failures that are quickly rectified may be bullish signals if they reveal massive consumer demand and a quick response by the company. This investment thesis should not be applied to businesses whose customer service failures seem chronic and institutionalized, like for instance, certain U.S. airlines and cable companies.

4) Adaptation is really hard for successful companies. AOL was not utterly blind to the fact that high-speed access presented a threat to its dial-up subscriber base. The company did experiment with broadband offerings and "Bring Your Own Broadband" discount packages for email and instant messaging. But it does seem that corporate hubris prevented AOL from striking deals that could have blunted the threat from broadband. At its peak, AOL was notoriously high-handed in negotiations with business partners, and it's easy to imagine how AOL (who thought it owned its customers) and cable companies (who thought they owned their customers) might not come to agreement on a business deal. Publicly, AOL dismissed the threat from broadband as in this comment from Bob Pittman (also reported by Saul Hansell) ten years ago.

"''Broadband doesn't sell itself,'' Mr. Pittman said in an interview. ''There is a small group that says 'Yeah, it's faster.' '' But high speeds don't make a difference to the activities that AOL members use most, he added, saying, ''Your E-mail doesn't get any better with broadband.'"

Maybe Pittman actually believed this. Or maybe this was a corporate posturing for the financial markets or for negotiations with cable and phone companies. Maybe it was all three. But when a charismatic corporate leader makes public statements like this, he runs the risk that his employees will believe it and act accordingly.

Absent a broadband strategy, AOL increased its bets on content, culminating in the ill-starred merger with Time Warner, which was a bold attempt to leverage a temporary advantage in dial-up internet access into permanent leadership as a content provider. But sometime this year, that deal will finally be unwound, leaving only bitterness and decimated Time-Warner 401(k) plans behind. More recently, AOL has let go of its paying subscribers (who were leaving in droves anyway) while shifting its emphasis to ad sales. But today looks like a smaller and much less popular version of Yahoo. In the current ad recession, Yahoo -- the second most popular destination on the web -- has struggled to regain its former glory. Tim Armstrong faces the same challenge, but from 35th place.

Note 1. Time Warner announced that it repurchased Google's 5% stake on July 8 for $283 million, a price that includes "cash distributions owed to Google". Google made its investment in AOL in December 2005. According to this pre-spin off filing by AOL, net distributions from AOL to Time-Warner in 2006 through 2008 come to $2.85 billion (page F-5). Assuming Google was owed a pro rata interest in these distributions, the "cash distributions owed to Google" may have been as high as $150 million, suggesting that Google is accepting a mere $133 million for its 5% stake in AOL, which would imply a total equity value of $2.66 million, or 2.5x run-rate EBITDA (or OIBDA as AOL prefers it) based on the June quarterly OIBDA of $271 million (see page 19). This extremely low-sounding valuation may be plausible as subscriber revenue, which undoubtedly has a high contribution margin to OIBDA, shrunk by 27% over the prior year quarter. If subscriber revenue is halved from its June quarterly result of $356 million with no corresponding cost reductions, quarterly OIBDA would be just under $100 million, and a $2.66 billion valuation would imply a 6.6x OIBDA multiple.

Note 2. On July 30, Michael Nathanson of Bernstein Research published a report (subscription required) on Time-Warner. Nathanson estimates that "cash distributions owed to Google" made up approximately $100 million of the $283 million Time-Warner paid Google for its 5% stake in AOL. This would imply an equity valuation of $3.66 million for all of AOL.


  1. Since AOL has begun trading (at an equity market cap of approximately $2.5 billion) the WSJ and Barron's have weighed in with conflicting views on the attractiveness of AOL shares:

    $180 Billion Later, AOL Shares Are Finally a Bargain - Barrons

    Time to Hang Up on AOL - WSJ

  2. In a twist, Saul Hansell has announced that he is leaving the NYT, where he covered AOL, to take a new position as Programming Director of AOL's