Yesterday’s Wall Street Journal carried an article confirming the rumors I have been writing about concerning major changes at AOL. The most important takeaway is that AOL wouldn’t be considering such drastic action unless the deterioration in fundamentals was accelerating. That means dial-up subscribers are still leaving at a fast clip, broadband subscribers under the company’s latest offer are falling short of expectations, and traffic and advertising at AOL.com is failing to hold market share. Regardless of how management spins the numbers when the strategy shift is formally announced, AOL is in big trouble and worth a huge discount to the $20 billion implied value from Google’s acquisition of a 5% stake…..

Let’s start with the basic numbers. AOL has a run rate of about $8 billion in revenue and $1.75 billion in EBITDA for a margin of about 22%. At the end of the first quarter, AOL had 18.6 subscribers paying a monthly ARPU of $18.43. According to the Journal, the company anticipates losing 8 million subs and $2 billion in subscription revenue by shifting to a free service for users with a broadband connection. Those numbers imply the subs that will walk away pay about $21 per month. The article makes little mention of lost profits but at the total AOL margin of 22%, lost EBITDA on $2 billion in revenue is $440 million. My guess is that the loss will be higher than that because dial-up subs probably have above average profitability.
Another way to look at it is that operating expenses at AOL are $6.3 billion (revenue minus EBITDA). Therefore, to breakeven on EBITDA, AOL would likely have to cut at least 10% of its cost base. The Journal says the new “free” strategy will come with huge cuts in marketing and customer service. Spencer Wang of Bear Stearns had a note out yesterday stating that headcount could be but by 80% in call centers and 50% in non-call centers. Marketing spend will likely go to $0 other than what is spent to acquire traffic via the internet. Given this math, it seems to me that the cost savings could be there.
However, that really doesn’t solve the problem. In 2005, AOL had subscription revenue of over $6.7 billion, representing over 80%of total division revenue. Essentially, this new strategy acknowledges that over time, except for a few million stragglers, all of the subscription revenue is going away. That means advertising is the sole revenue stream available to replace and grow the $1.75 billion EBITDA base. That is a huge hurdle when you consider that in 2005, advertising at AOL was $1.4 billion. Assuming advertising grew at 25% annually for three years, it would be approaching $3 billion. Yahoo (YHOO) had an EBITDA margin of 42% in 2005 (Google was much higher). It is doubtful that the AOL as the #3 or #4 portal player could approach industry leading margins but even if they matched YHOO, advertising EBITDA would only reach about $1.2 billion. At that point, subscription EBITDA would be just a fraction of what it is today so the best case scenario might allow AOL to just maintain its EBITDA over the next several years.
Given the alternative, which is a slow draining of EBITDA until it drops by 50% or more in the next five to ten more years, I suppose AOL has no choice but try something different. But different doesn’t necessarily mean success. Execution risk will be very high and there is a good chance that near-term EBITDA takes a big step down before it is rebuilt on advertising. And there is no guarantee advertising will carry the day. AOL is a weak and stale brand. It just might not be salvageable.
For TWX, I think the implications are dire. Essentially, management is admitting that as currently structured, AOL has much less value than many analysts and investors had assumed. My model uses a 10 multiple for AOL and I still value TWX at little more than $20. The reality is the failure of the current AOL strategy means that a mid-single digit multiple is more appropriate. Each multiple point is worth about 50 cents per TWX share. Put a 6 multiple on AOL and you shave $2, or 12%, off the value of TWX. Ouch.
I see no reason to get involved in TWX. AOL is a depreciating asset. Advertiser supported businesses at publishing and cable networks are growing very slowly and face secular challenges. That leaves cable. I like cable but I am not sure that upside to cash flow and valuation at cable is enough to drive TWX shares significantly higher. Better opportunities exist elsewhere in the market and in media stocks. Maybe when he folded his fight, Carl Icahn realized that the value at TWX is not really what it seem