NOT AN ANALYST

AOL reported on February 3^rd its 4Q results for the first time as an independent entity. The report provided few positives but the overall picture remained extremely weak.

Positive notes Domestic display, which accounts for 30% of total revenue, grew 1% Y o Y and 25% Q o Q, indicating that AOL is participating in the cyclical recovery of online advertising.  

The balance sheet remains strong with 147 mm in cash on hand and 130 mm of FCF generated in the quarter. The stock currently trades around 3x 2010 EV/EBITDA based on an estimated EV of 2,468 mm and EBITDA of 823 mm for 2010.

Several negative notes Advertising revenue declined 8% Y o Y, impacted primarily by weaknesses in the international market, where display revenue decreased 22% Y o Y. AOL called for an accelerated decline and possible closing of its international properties in the recent future if the negative trend continues. Domestic AOL subscribers declined 27% Y o Y, affecting subscription revenue significantly. Overall, revenue declined 17% Y o Y, although this was “less worse” than the 23% experienced from Q1 to Q3, it remained very weak as expected.

It’s important to add that the management team is fairly new and unproved at AOL. At least four top level employees, including the CEO, have joined the firm less than a year ago (Tim Armstrong, Jeff Levick, Brad Garlinghouse and Jon Brod). They certainly bring a fresh prospective to the Company, but it will take some time before they will be able to make a turnaround at the firm. However, there is no guarantee that a turnaround can or will happen anytime in the future.

AOL outlook The Company remains on my watch list for the “stocks to short” for 2010. I guess the question that I would like to ask AOL management would be “What are you planning to do with cash on hand and how do you plan to capitalize on your strong balance sheet position?” AOL has certainly a lot of cash and could potentially use some more leverage to finance new projects like the acquisition of content sites or the purchase of new technologies to build platforms. As of now, I don’t see any initiative from the management team into that direction. Let’s wait and see.

AOL Spin-off On December 10 2009, AOL started to operate as a standalone entity and began trading on NYSE under the ticker “AOL”.  The Company has been spun off from Time Warner, which AOL acquired for 164 billion a decade ago. I am not going to go over the reason of the separation, but it became evident how AOL has been losing market share since the consolidation with Time Warner in 2000.

Investment thesis It’s hard to see any potential price appreciation, given the continuing deteriorating fundamentals. The stock can trade lower on a series of catalysts: additional goodwill impairments, higher than expected deterioration in subscription and/or advertising revenue and a rise in price without any fundamental change. I will keep it under the “stocks to short” list for 2010.

Shift in Business Given the declining revenue base and negative EBITDA growth experienced in the last 5 years, mainly attributable to a steep decline in subscription based revenue, the Company decided in 2006 to shift its core operation from subscription to advertising. However, results have not been great as competition from other popular sites like Google and Yahoo and/or social networking sites like Facebook and Twitter has been very intense. AOL’s new business focuses on five core business segments:  

• Web content; create and publish new original web content through its various site categories.
• Local and Mapping; provide local content, platforms and services covering geographic levels ranging from neighborhoods to major metropolitan areas like MapQuest,  Local Entertainment Guides, Local Directories and Local Events.
• Communications; email and instant messaging products and services like AOL Mail, ICQ and AIM.
• Online Search; offered through AOL Search and AOL Media, currently outsourced to Google.
• AOL Ventures; the investment/acquisition arm of AOL

Valuation I expect advertising revenue to decline 5% in 2009 and continue to decrease at a 5% rate every year after. Subscription based revenue will be 1,350 mm in 2009 and continue to decline at a 30% rate each year after. EBITDA margin will be 30% in 2009 and shrink 1% each year after, as a result of the continuation of the historical trend that saw operating revenue decline more than COGS and operating expenses. The Company is expecting to receive 250 mm Credit Facility with a maximum consolidated leverage ratio (total debt to EBITDA) not greater than 1.5 to 1.0 and a minimum consolidated interest coverage ratio (EBITDA to consolidated cash interest expense) of at least 4.0 to 1.0. Under the financial covenants, the Company can use up to 100 mm a year for acquisitions. Other than that, AOL has almost no debt; total fixed obligations due before the end of 2014 total 622 mm and are comprised of property and other operating leases. Liquidity doesn’t seem to be an issue; FCF will be the positive but decline in the coming years due to deteriorating fundaments. Given 823 mm of EBITDA in 2010, the Company currently trades at 3x 2010 EV/EBITDA, a discount compared to the average 2010 EV/EBITDA multiple for the top Internet Advertising Companies (7.9x) and Media Companies (7.3x). Cash generated from working capital in 2009 was mainly driven by changes in accrued compensation as the Company decided not to pay annual bonuses to employees related to 2008 performance.

Catalysts for a short sale An advance in price to 30 dollars per share or higher due to overall market appreciation without any change in fundamentals is the signal for a potential short opportunity.

If the Company deems that 50% of the fair value of goodwill is lower than then its carrying value, therefore impaired, the share price should drop by 10 dollars. In accordance with FAS 142, goodwill is tested for impairment at least annually. The fair value of the reporting unit is calculated using a DCF approach and a market approach. For the 2008 goodwill impairment analysis, the Company increased the discount rates utilized in the DCF analysis to a range of 13% to 15% from 12% in 2007, while the terminal growth rates for the advertising revenues were decreased to a range of 2.5% to 3% from 4.5% in 2007. What does this mean? Higher discount rates and lower growth rates produce a lower current value. There is a good chance of further adjustment in growth rates and/or discount rates, therefore potential impairments charges, if subscription based and/or advertising revenue deteriorates further from current levels. As of September 30 2009, 50% of the total asset or 2,175 mm is comprised of goodwill.

Conclusion I am keeping AOL under my list of stocks to short as it faces many challenges: The market place where it operates is highly competitive especially from Companies like Google, Yahoo, Microsoft, Facebook and Twitter and fundamentals are deteriorating quickly, increasing the chance of further impairments. The shift is strategy implemented in 2006 is towards the right direction but the company doesn’t seem to do enough to win market shares, mostly due to negative user experience built during the past years poor search results and lack of innovation.