The Time Warner AOL spinoff values AOL at about $3.2 billion (pre-spin). This valuation is a reasonable 1X multiple of revenue. More importantly, it sets a very low bar for the stock going forward.
AOL has all sorts of problems, which we have described in detail here. But the spinoff valuation is low enough that the company should be able to generate enough cash to justify it even if the turnaround fails and AOL eventually dwindles away to nothing.
Thanks to AOL’s dying subscription business, revenue and operating income will likely decline for the next several years. But major cost cuts will keep cash flow strong, and Tim Armstrong will likely be able to at least stabilise advertising revenue next year. Given that most people have written AOL off for dead, this sets the table for a modest positive surprise.
In short, even if AOL keeps crumbling, it will likely throw off $3 billion of cash before it dies. One way of looking at the stock, therefore, is that you get an option on the turnaround for free.
Below, we estimate how much cash AOL will generate over the next few years. We also introduce the world’s first AOL EPS estimates. To wit:
2010E EPS: $3.20
2011E EPS: $2.80
2012E EPS: $2.45
We’ll adjust those estimates when we see the magnitude of AOL’s cost cuts, which should take place just after the spinoff.
AOL’s dying subscription business currently generates nearly all of the company’s profit. AOL will also announce major cost cuts in the next few weeks that will boost the margin on the media business. So, despite the declines in the subscription business, the outlook for cash flow next year is good.
Below, we forecast AOL’s cash flows and then value the company using a number of different methods. Based on this, the $3.2 billion valuation Time Warner has placed on AOL seems reasonable. Here is how we get there (download the entire spreadsheet here):
Access Revenue Likely To Shrink From $1 Billion To $500 Million By 2013
We estimate subscribers should decrease 10% to 20% per year before levelling out at about 2.8 million subs in 2013 (dialup is hurting but not completely going away). Importantly, however, the business should continue to generate cash. With mostly variable costs, the EBITDA margins on this business should fall to about 50%.
AOL’s Ad Business Should stabilise Next Year, At Least Temporarily
We believe traffic at AOL’s media properties will continue to decline as it loses referral traffic from lost access subscribers (see TBI article on this here). Since we estimate about 25% to 50% of AOL Media’s traffic comes from the access business and access subscribers should decline about 25% per year, page view declines driven by the loss of access subscribers should be about 12% per year until access stabilizes.
However, we believe Tim Armstrong’s new sales team will likely be able to counter some of those page view declines with more premium ad deals that sell more inventory at higher rates than in past years (AOL’s sales force has had its share of problems in the past). As a result, we believe revenue will decline about 5% next year at AOL Media, then return to modest growth by 2012.
We believe ad network revenue should increase about 5% per year to 2013, in-line with what we believe the overall network industry will do.
After December’s layoffs and some ongoing operating efficiencies each year, we believe EBITDA margins should be in the 20% range for the ad business.
Overall, AOL’s Revenue Will Likely Shrink From $3 Billion To $2 Billion By 2013
If AOL can successfully execute on its strategy to wind down its access business while growing its ad-driven business into a profit centre, we believe it could generate about $2 billion in revenue by 2013 with 30% EBITDA margins and 25% free-cash-flow margins.
If AOL’s Ad Business Stabilizes, The Stock Could Trade At $40 In A Year
This company is unusual in that, barring a miracle, revenue and cash flow will likely shrink for several years. Investors aren’t used to hearing stories in which that’s the case, so valuation is tricky.
Again, the premise here is that AOL will throw off about $3 billion of cash over the next five years even if things don’t go splendidly. So an unexpected turnaround would represent upside.
In the interim, if media revenue stabilizes, the stock’s multiple will likely expand. If AOL looks like it is going to continue to go out of business, it will compress.
We think that Tim Armstrong will be able to make AOL appear to be recovering, at least for a while. So we think there’s a good chance the market gets excited (or at least less depressed) about the story for a while.
In any event, a $40 share price would be about 7X our 2011 estimated free cash flow.
Tech P/E multiples range from about 10X to 20X currently, and we believe AOL should be at the low end of that range given the risks to its strategy and shrinkage. AOL will continue to pile up cash, though, so the overall multiple should reflect that.
We think an EPS multiple of 12X to 14X is reasonable, which results in a 12-month price target of about $34 to $39. Below is our forecast P&L for AOL as well as a range of price targets given different P/E multiples.
SEVERAL METHODOLOGIES POINT TO $3.2 BILLION VALUATION BEING REASONABLE
It’s difficult using standard valuation methods that typically apply multiples to next year’s earnings for AOL since it will be in a restructuring period for a couple years before its long-term viability as a company becomes clear. Therefore we look at a number of different methods to determine that $3.2 billion is probably a reasonable valuation for the company as a standalone entity.
Discounted Cash Flow Analysis: $3.8 Billion
- 20% discount rate given risk to AOL’s turnaround strategy.
- 7% long-term free-cash flow growth.
Enterprise Value/EBITDA: $3.0 Billion
- 4-times multiple much lower than peer group given risk, lack of growth, and margins.
Free-Cash-Flow Multiple: $3.7 Billion
- 6-times multiple much lower than peer group given risk, lack of growth, and margins.