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November 02, 2005

Time Warner: Will AOL Finally Show Good Advertising Growth

Given the critical role that AOL will play in the perception of TWX's quarter I wanted to mention an interesting piece of research Bernstein put out last week about advertising revenue at the MSN division of Microsoft (MSFT).

I switched to a bullish position on TWX in September based primarily on my belief that the relaunch of AOL.com as an open portal was going to be well received by advertisers in its first few quarters. Given that AOL is the key swing factor in the value of TWX shares and multiple expansion for AOL is largely dependent on the Street's view of organic advertising revenue growth, any uptick in AOL's organic advertising growth is likely to be well rewarded by the Street. My impression from reading analyst research and checking with another non-Street contact is that advertisers are willing to give AOL.com an opportunity over the next couple of quarters. In fact, I've read that AOL largely sold out its advertising on AOL.com for the fourth quarter.

This foots back to the Bernstein report where the analyst noted that in MSFT's just reported quarter, MSN advertising growth was just 20% year-over-year vs. over 100% for Google (GOOG) and over 40% for Yahoo (YHOO). On a sequential basis, ad revenue at MSN actually fell by about 10% vs. a gain of over 10% at GOOG and over 5% at YHOO. The Bernstein report suggested that MSN's growth probably lagged due to paid search. MSFT management said that display was up sequentially, which implies that search had be down significantly on a sequential basis.

The report did not mention AOL. However, my first thought was that if what I am reading about advertiser reception to AOL.com is true, maybe AOL is also partially responsible for the loss of market share at MSN. In fact, since AOL represents a significant portion of GOOG's paid search revenue, maybe GOOG's 3Q revenue growth explosion is a tip-off of a pickup at AOL.com that began to appear in TWX's 3Q. I am not saying that AOL is driving GOOG, not by any stretch, but one way to analyze the numbers from GOOG, MSFT, and YHOO is that AOL may be performing better on advertiser revenue than it has in recent quarters. Remember that after adjusting for the Advertising.com acquisition, AOL has lost market share so far this year as its ad revenue has sharply lagged GOOG, YHOO, and MSN.

I am not sure if this thesis is correct. We'll learn more once TWX reports. In fact, the thesis may be accurate but early as 4Q might be when a pickup in AOL ad revenue is first evident. TWX is guiding to a sluggish 3Q and a big pickup in 4Q for the entire company. The street sees most of the 4Q strength in Filmed Entertainment but AOL advertising will contribute to 4Q strength as well.

If AOL ad strength happens to appear in the 3Q numbers, it will be a pleasant but not wholly unexpected surprise. Remember, each multiple point increase in AOL's valuation is worth 45 cents or about 2.5% to TWX's share price. My $22 target on TWX used just a 5 multiple for AOL. We all know that GOOG and YHOO trade north of 20 times EBITDA.

Posted by Steve Birenberg at November 2, 2005 11:04 AM in TWX