In a regulatory filing this evening (see page 54), Time Warner announced that it bought back Google’s stake in AOL, for a 97% discount to what it paid in January 2000. If AOL stock gets floated at a similar valuation, it might be a good value play.
First the news:
On July 8, 2009, Time Warner repurchased Google’s 5% interest in [AOL] for $283.0 million, which amount included a payment in respect of Google’s pro rata share of cash distributions to Time Warner by AOL attributable to the period of Google’s investment in us. Following this purchase, we became a 100%-owned subsidiary of Time Warner.
Divide $283 mil by 5% and you get a valuation of $5.7 billion for AOL. When Google bought its stake back in 2005, it paid $1 billion, valuing AOL at $20 billion overall. When Time Warner and AOL merged in 2000, AOL was valued at $166 billion. From that peak, AOL’s valuation has now fallen 97%.
Google takes a sizable paper loss on its investment, but in the end it was still a great strategic move for them to lock up AOL’s search distribution. A big reason Microsoft and Yahoo have never been able to catch Google in search is a simple matter of scale. Most advertisers needn’t bother devoting any of their search advertising budget to Yahoo or MSFT because neither one has enough share of search distribution—does ANYone search using Yahoo.com or MSFT’s Bing?—to make it worthwhile. Google ends up monetizing its own search traffic better because the depth and breadth of keyword bidding on its network is so much greater. And because monetization is higher, web publishers prefer to work with Google too, increasing Google’s distribution even more.
It’s a virtuous circle that will allow Google to keep a hammer lock on the search market for a long time to come.
Ironically, advertisers often pay far LESS for clicks on Google than on Yahoo. Yahoo still has a minimum bid of 10 cents for its keywords. Google charges advertisers as little as a penny or two for lower volume keywords.
(By the way, the rationale behind paying up to lock down AOL’s search traffic was the same one behind the $900 million guarantee Google gave MySpace to lock up its traffic. Another shrewd deal for Google).
So will AOL stock be a good investment when the company is spun out from Time Warner? Possibly. According to the company’s cash flow statement (see page F-5), it generated free cash flow of $762 million in 2008. That amount of FCF, vs. an overall valuation of $5.66 billion, puts the company’s FCF yield at a very reasonable 13.5%.*
But investors have to tread carefully. Yeah, the valuation seems cheap, but free cash flow continues to decline.
Before making an investment, I would want to understand the company’s two businesses in more detail, both the legacy dial-up subscription business and the advertising business. Dial-up is bleeding to death. But advertising may have a future. The key questions are: can the advertising business continue to thrive after dial-up dies? Also: What is each business’s contribution to free cash flow?
If advertising drives earnings, and it can survive on its own, then the stock may indeed be a great value.
Before closing I should note that I am not making an investment recommendation here. I just thought readers might find a discussion of company valuation a nice change of pace. These are all questions we’ll want to ask when (if?) Treasury/Fed/FDIC get out of the market….
*for a comprehensive discussion on FCF yield, and why it’s a better method to measure company valuation than a simple P/E ratio, see the 3-part tutorial on my old blog.