Summary
- AOL’s reinvention as a digital media company means lower margins and less stable revenue streams.
- Investors are underestimating how big a drag on growth the legacy subscriber business will be going forward.
- The current valuation prices in way too much growth for a company with uncertain prospects.
Check out this week’s Danger Zone Interview with Chuck Jaffe of Money Life and MarketWatch.com.
AOL Inc. (AOL) is in the Danger Zone this week. This Web 1.0 figurehead is trying to sell investors on its reinvention as a digital media company. It appears that too many investors are buying that story as the stock is up over 140% in the past two years. The stock has a long way to fall once more investors recognize the weakness of AOL’s legacy membership service as well as the inherent instability of its new business.
Where Are Profits Coming From?
AOL is divided into three reportable segments: the Membership Group, the Brand Group, and AOL Networks. The membership group encompasses AOL’s 2.5 million paid subscribers as well as advertising revenues from properties like AOL Mail. These legacy services are in decline. AOL is losing subscribers, and Membership Group revenue has declined by 19% over the past two years.
AOL’s other two groups, the Brand Group and AOL Networks, are the new businesses that have excited investors. The Brand Group encompasses AOL properties like aol.com, the Huffington Post, TechCrunch, and many others. AOL’s revenue from ads on these sites grew by 9% in 2013.
AOL Networks consists of several different advertising platforms, such as Advertising.com and Adap.tv, which connect video advertisers and online publishers. AOL Networks grew revenues by 22% in 2013.
While revenue growth at AOL Networks and the AOL Brand Group looks good, a look at AOL’s operating results by segment shows why investors should be worried. Figure 1 shows just how dependent AOL still is on its Membership Group for profits because the new businesses are barely making any money.
Figure 1: Operating Income Before Depreciation and Amortization (OIBDA) by Segment
Sources: New Constructs, LLC and company filings
AOL’s declining Membership Group contributed almost $600 million in reported pre-tax operating income, while its Brand Group and AOL Networks combined contributed $25 million. AOL is still remarkably dependent on subscribers and users of outdated services like AOL mail. Even if its other two segments can become profitable, they will have to offset the continued decline of the Membership Group.
Cost Cutting Can’t Continue
The bull case for AOL also centers around its impressive recent profit growth. AOL grew after-tax profit (NOPAT) by 53% and 40% in 2012 and 2013 respectively. They key to this growth can be seen in the “Corporate and Other” row in Figure 1.
