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Feb 8, 2011

AOL Acquires Leading Media Company
(2011 Version)

This post was updated February 14, 2011 with a different version of the graph below.  The scaling on the graph has been changed as well as the value for Twitter as explained below.  The original version of this post is available at Seeking Alpha.

Last Sunday, AOL announced the acquisition of the Huffington Post for $315 million. The acquisition is right in line with the strategy Armstrong has articulated for AOL, and the management team deserves credit for its focus and decisiveness. Time will tell if they overpaid; it's notable that the HuffPo's shareholders took 95% of the purchase consideration in cash even as AOL's stock price is bumping around its all-time lows.

The ensuing press coverage is way out of line with the importance of the deal, probably because $315 million seems like such a big number for a five-year old, controversial and unconventional news site.

But most remarkable about this deal is how "conventional" it really is. AOL is simply amassing a stable of media titles under one umbrella, with the hope that it can figure out some scale economies before the cash flow from its dying ISP business runs dry. Michael Wolff has a pithy column on this topic here.

AOL is unabashedly becoming a content farm, much like the recently IPO'ed Demand Media. But with HuffPo and some of its other brands, AOL seems to think it can slap a brand name on its product (think "Chiquita" or "Sunkist") and get a small premium compared to generic produce. This may be a survival strategy, but it lacks the scalability to make it a big winner online.

After all, there are other brand name content providers on the internet, and this strategy hasn't really worked for them either. The websites of most metro newspapers in the US offer some pretty high caliber content, but revenue and a profitable business model remain elusive. The problem is not solved by replacing so-called "high priced" talent -- go ask a journalist how well she gets paid -- with low-cost freelancers generating search-engine optimized ad bait, because that's not the problem.

The problem is that, on the internet, there's a lot less value to the curation and aggregation of content (and ads) than there was in the pre-internet days when your local newspaper had a quasi-monopoly on the process. (See related post here).  The value created by "organizing the internet" is captured by search sites like Google and social media sites like Facebook and Twitter that direct users to relevant content.

Take a look at the following graph, which plots "enterprise value" (the value of all of a company's stock, plus its net debt) against revenue for various companies.

(Click on chart to enlarge)
At the top, there are three highly scalable businesses: Google (GOOG), Facebook (FB) and Twitter, whose business models are based (currently and mostly) on the sale of advertising against content supplied by others. For Facebook I have assumed $1.8 billion in revenue and based on recent report, $50 billion of enterprise value. For Twitter, $45 million in revenue, $6 billion in enterprise value, halfway between the $4 billion value in its last financing and the $8 billion being rumored in a possible sale to Google or Facebook.

Then there are some traditional newspaper companies, the New York Times (NYT) and McClatchy (MNI). These two publicly listed companies are mostly "pure play" newsgathering companies working through the transition to the online world. Clustered among them are Demand Media (DMD), AOL and HuffPo, online media companies pursuing a distinctly conventional approach to curating and aggregating content.

Finally, I have added Yahoo! (YHOO), which is a bit of a tweener and the company AOL probably aspires to be... or to be acquired by. (see Note 1.)

Note that the axes are logarithmic scales. Adjusted for company size (since valuation is highly dependent on expected growth and hyper-growth gets harder as a company gets larger) market valuations are roughly 10x greater for the scalable businesses than for the content aggregation businesses. This is not surprising, since the scale economies in these businesses provide meaningful growth opportunities at enviable profit margins, something that investors used to say about newspapers.

I expect AOL will continue to acquire as its bank account and stock price permit and a merger with Demand Media would be a way to add acreage to the content farm, while eliminating the temptation for both companies to over-produce and drive down the value of their ad inventory. One can even imagine AOL merging with a traditional media company so long as the merger partner could suffer the inevitable comparisons with the ill-fated AOL-Time Warner merger a decade ago.


(Note 1. I have reduced YHOO"s enterprise value by approximately $7.5 billion, my estimate of the after-tax value of YHOO's passive investments in Alibaba and Yahoo! Japan in order to show a "pure play" value for the company.)

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