AOL’s got independence – and issues

December 11, 2009

The AOL-Time Warner merger was the crowning deal of the new millennium. The spin-off on Thursday of the internet business from Time Warner is an appropriate bookend to a lost decade in the stock market. There may be value left in the online operation, but it won’t be easy for chief executive Tim Armstrong to extract it.

When AOL announced it was buying Time Warner 10 days into 2000, the two companies had a $350 billion market value. Today their combined value is just $50 billion, a decline of 86 percent – even worse than the Nasdaq’s 45 percent decline.

Nonetheless, the divorce is a healthy decision. Time Warner management is no longer distracted and can deal with bigger problems in its core print and media businesses. AOL too can move forward without the shackles of a bureaucratic corporate parent.

But the going will be tough for Armstrong. He wants to convert the company into a content and advertising play, but according to RBC Capital Markets, as much as a fifth of AOL’s traffic comes from dial-up internet subscribers checking email and such. So the continued decline of AOL’s access business – 5 million subscribers today compared to 26 million in 2002 – does more than pressure overall company cash flow. It threatens the company’s transformation to a pure content business.

Bulls point to AOL’s apparently cheap valuation – its enterprise value of $2.4 billion is just five times projected free cash flow for 2010. But much of that cash comes from the declining access business. There may be opportunity to improve advertising profit margins in line with peers. That’s what management is targeting, though they concede it will take at least a few years.

Armstrong is essentially in a race against time. He must reinvest much of the cash from the access business into content to get the wider internet audience to re-engage with his site. AOL managed to survive a choppy decade. But it may not endure the next.

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