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.

What is a spin-off? The parent company (ParentCo) distributes to its existing shareholders new shares in a subsidiary, thereby creating a separate legal entity with its own management team and board of directors. The distribution is conducted pro-rata, such that each existing shareholder receives stock of the subsidiary in proportion to the amount of parent company stock already held. No cash changes hands, and the shareholders of the original parent company become the shareholders of the newly spun company (SpinCo).

Reasons for a spin-off Divesting a subsidiary can achieve a variety of strategic objectives, such as:

• Separate an unrelated business For example, a diversified company may have a fast growing software or Internet business that is largely ignored or not valued by the market because it is a small part of a large company. The fast growing division would likely garner a richer valuation as a stand-alone entity.
• Eliminating dissynergies Divest non-core businesses, reduce bureaucracy and give SpinCo management complete autonomy
• Unlocking hidden value Establish a public market valuation for undervalued assets and create a pure-play entity that is transparent and easier to value.
• Public currency Create a public currency for acquisitions and stock-based compensation programs
• Motivating management Improve performance by better aligning management incentives with SpinCo’s performance (using SpinCo, rather than ParentCo, stock-based awards), creating direct accountability to public shareholders, and increasing transparency into management performance
• Anti-trust Break up a business in response to anti-trust concerns
• Corporate defense Divest “crown jewel” assets to make a hostile takeover of ParentCo less attractive

Accounting for spin-offs The parent accounts for the disposition of its subsidiary in a single line item on its balance sheet called “Net Assets of Discontinued Operations”, or similar. The parent also segregates the net income attributable to the subsidiary on its income statement in an account called “Income from Discontinued Operations”, or similar.

Structure of a spin-off The parent company will often extract value from the subsidiary before spinning it off by levering up SpinCo and siphoning the cash proceeds as a special tax-free or pushing down debt to SpinCo. The special dividend and amount of debt pushdown are both limited in size to ParentCo’s inside basis in the subsidiary’s assets. If either exceeds the inside basis, the spin-off is taxable to the extent of the excess. The amount of debt ParentCo can push down to SpinCo is also limited by SpinCo’s ability to service the debt.

Let’s look at an example where a Company sought protection under the Bankruptcy code after a spin off: Verizon’s spin-off of Idearc, which I have talked about not long ago. The following is excerpted from Idearc 8-K filing detailing its spin-off from Verizon, and outlines how the spin off deal was structured

“On November 17, 2006, Verizon Communications Inc. (“Verizon”) spun off the companies that comprised its domestic print and Internet yellow pages directories publishing operations. In connection with the spin-off, Verizon transferred to Idearc Inc. (“Idearc”) all of its ownership interest in Idearc Information Services LLC and other assets, liabilities, businesses and employees primarily related to Verizon’s domestic print and Internet yellow pages directories publishing operations (the “Contribution”). The spin-off was completed by making a pro rata distribution to Verizon’s shareholders of all of the outstanding shares of common stock of Idearc.

In connection with the spin-off, on November 17, 2006, and in consideration for the Contribution, Idearc (1) issued to Verizon additional shares of Idearc common stock, (2) issued to Verizon $2.85 billion aggregate principal amount of Idearc’s 8% senior notes due 2016 and $4.3 billion aggregate principal amount of loans under Idearc’s tranche B term loan facility (collectively, the “Idearc Debt Obligations”) and (3) transferred to Verizon approximately $2.4 billion in cash from cash on hand, from the proceeds of loans under Idearc’s tranche A term loan facility and from the proceeds of the remaining portion of the loans under Idearc’s tranche B term loan facility.”

Often spinoffs are required to incur heavy debt loads, and FCFE can easily be eroded by high interest payment if growth prospects aren’t met, which makes the SpinCo a candidate for a short position.

Fraudulent Conveyance When SpinCo incurs a loan and distributes the proceeds to the ParentCo, as described above, creditor claims of fraudulent conveyance may arise if SpinCo later declares bankruptcy because it is unable to service its debt. Similar creditor claims may also arise if the spin-off leaves ParentCo insolvent. Therefore, it is necessary to ensure that both SpinCo and ParentCo are adequately capitalized following the spin-off.

Capital Markets implications The separate business entities created in a spin-off sometimes differ in many ways from the consolidated company, and may no longer be suitable investments for some original shareholders. Institutional investors committed to specific investment styles (e.g. value, growth, large-cap, etc.) or subject to certain fiduciary restrictions may need to realign their holdings with their investment objectives following a spin-off by one of their portfolio companies. For example, index funds would be forced to indiscriminately sell SpinCo stock if SpinCo is not included in the particular index. Also, the lack of a dividend may push income-oriented investors out of the spun off stock.

So why invest in spin-offs? Companies that have been spun off usually trade at a significant premium or discount compared to their peers. The spin off world is littered with many dogs and horses. Also there is often an absence of adequate financial information when the SpinCo commence trading as a standalone entity and the stock it’s mispriced. This a good reason for coverage on the Blog because a well written valuation can take you a long way.

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.

Terms of the MSG Spinoff Cablevision (CVC) announced on July 30^th that its board of directors approved the spinoff of the Madison Square Garden (MSG) business to CVC shareholders. The transaction is expected to be finalized in the 1Q of 2010. MSG will assume 375 mm senior Revolving Credit Facility for 5 years to fund working capital needs, capital expenditures related to the renovation of the Madison Square Garden Arena and general corporate purposes. An important note is that MSG is expecting 190 mm from Rainbow Media Holdings, another subsidiary of CVC, as a repayment of demand loan (non-interest bearing). CVC announced that once MSG is spun off, the loan will be repaid.  The new MSG’s assets will include:

• Media Properties, including MSG, MSG Plus, and Fuse Network
• Sport Teams like New York Knicks of the NBA, New York Rangers of the NHL
• A live entertainment portfolio, including proprietary radio as well as concerts, shows and events.
• Leading venues, highlighted by the Madison Square Garden and Radio Music City Hall.

Valuation Its unsure how much cash MSG will have once it will operate as a standalone entity, but after reading the last three10K and the latest 8K reports of CVC, we can get an interpretation of how much MSG could be valued. Let’s start with the assumptions.

• MSG will have 290 mm in cash on hand as a standalone company, comprised of 190 mm from the repayment of the inter-company loan and 100 mm on hand.
• Capital expenditures for renovating the Madison Square Garden Arena will be 800 mm over three years with 60 mm accounted before the end of 2009 as pre construction expenditure. After 2012, once the renovation is expected to be completed, capital expenditures will be reduced to the historical levels of 55 mm per year.
• The Revolving Credit Facility will be fully drawn in 2011 and will be refinanced with a 700 mm new Term Loan in 2014. Each Loan will bear 600 bps interest rate
• EBITDA will drop 5% each year from the previous year in 2010 and 2011, as renovation will prevent full access to the Madison Square Garden Arena. Upon completion of the renovations, EBITDA will grow at 25% rate y o y under the conservative scenario and at a 50% rate y o y under the aggressive scenario.  

Post MSG spin off analysis The valuation is the same under both scenarios up to 2012, which is when the renovations are expected to be terminated. Beyond that point, if you believe a 50% growth in EBITDA, you will end up in 2014 with 33 mm in cash and 76 mm in FCFE and. If you believe in a 25% growth in EBITDA, then you will end up with no cash and 11 mm in FCFE. In both cases, leverage doesn’t seem to be an issue, but it looks like the Company is using a lot of borrowed capital to improve assets without generating enough return. This seems to be the problem that MSG always had, the Company has valuable assets but the margins are thin and have been shrinking as higher expenses and competition eroded returns over time. Also, my valuation is fairly generous; as it assumed a small amount in working capital needs and conservative capital expenditures. The Company estimated that renovation costs can total 850 mm. In addition, it will be important to know the covenants of the Revolving Credit Facility, especially minimum EBITDA and liquidity levels for the next 5 years.

Conclusion The MSG spin off will benefit Cablevision more that MSG itself, as the transaction will remove potential negative cash flows and high capital expenditures from the parent. I am not confident about the earning potential of MSG, as the media industry doesn’t seem to be recovering from the economic downturn. The Company has planned to make a lot of capital expenditures, but will EBITDA growth be enough in the years to come to justify them? I highly doubt that. Remember that the Entertainment and Sport segment of MSG use the Garden Arena to conduct their business, which amounts to 65% of the total revenue based on 2008 numbers. We will continue coverage once the spinoff is concluded.