analysing AOL: How Bad Was Q2? What's It Worth?

Now that the shock of AOL’s Q2 ad-revenue deceleration has worn off, it makes sense to take a closer look at the business.  How bad was the quarter, really?  How is the turnaround going?  What’s it worth?  The answer to all these questions are more positive than you may think.

Users.  First, more importantly, the single most important factor in AOL’s future is its ability to attract new users.  Generating more pageviews from existing users is nice, but it won’t really get the company’s growth going again.  How’s is AOL doing in this crucial area?  Showing a slight improvement: Users increased to 114 million in Q2 versus 111 million in Q1.  This doesn’t sounds like much, but at least users aren’t fleeing.

On the pageview side, a.k.a. “engagement”, the headline number showed an eye-popping improvement of 18% sequentially, but CFO Wayne Pace was good enough to tell us that that majority of this gain was the result of tracking-methodology changes.  AOL estimates that on an apples-to-apples basis, pageviews increased 4% sequentially, slightly faster than users.  So the company is seeing increased engagement, which is positive: more pageviews mean more advertising revenue per user.

Legacy business.  Second, how long will AOL’s paying subscribers continue to deliver hundreds of millions of dollars a quarter to the bottom line?  There is actually good news here, although, as Churchill might have said, it was effectively disguised… 

AOL’s paying subs continued to stream out the door: Since the decision to “go free,” quarterly subscription revenue has dropped from $1.5 billion to $700 million.  On the other hand, AOL is now available for free–and the company is still generating $700 million a quarter ($2.8 billion run-rate) in subscription revenue.  This number will continue to drop every quarter–it’s down from $900 million in Q1–but it appears as if it will hold on for a while longer.   It’s hard to tell how profitable this revenue stream is–on the dial-up side, there are significant variable network costs–but subscription revenue is presumably still delivering significant operating cash flow to the bottom line (at least $250 million a quarter, assuming the ad business has a 50% contribution margin).  Which isn’t bad for a product the company is now giving away.

Advertising Revenue.  One major reason for the ad revenue slowdown, which some analysts expecting another 40% gain might have missed, is that the Google search deal anniversaried this quarter.  As a result, search revenue increased only 6%. Display advertising on AOL increased 15%, which isn’t bad considering the pathetic growth at, for example, Yahoo.  The strongest ad revenue growth was at, which serves ads on third-party sites.  The bad news there is that ads sold on third-party sites are far less profitable than those sold on AOL’s overall network.  And AOL no longer expects to be able to grow ad revenue at the industry growth rate for the balance of the year.

Conclusion.  The turnaround is going OK.  Not great, but OK.  Even if subscription revenue went to zero tomorrow, the company’s ad business would probably throw off about $1 billion a year of operating cash flow (assuming the subs could be persuaded to stick around, which is a big assumption).  AOL has at least stabilised itself and can now focus on establishing a long-term growth plan.  And if Time Warner can’t figure one out (or is sick of the headache), AOL will likely be worth at least $10-$20 billion to someone.

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