AOL’s latest SEC filing largely confirms what we wrote a month ago:
- AOL’s dying subscription business generates substantially all of the company’s profit (the filing says “vast majority”)
- The media business–the company’s future growth engine–currently loses about $600 million a year
These problems aren’t insurmountable, but they are the reason AOL will be laying off another 1,000-2,000 people in a few weeks. They’re also the reason Time Warner has valued AOL at only $3.2 billion, or 1-times revenue.
In the next week or so, we’ll start looking at the properties within AOL that represent real, increasing value–the “ponies in there somewhere” that will have to drive the company going forward. In the meantime, however, it is important to understand the depths of the challenges AOL faces.
We have updated our breakdown of the company’s financials based on the company’s Q3 numbers. As we explained last month, here’s AOL’s problem in a nutshell:
- The dying subscription business contributes nearly all of the company’s profit and 25%-50% of its web traffic (which, in turn, powers the struggling ad business, both search and display).
- The advertising business, which is powered in large part by the subscription business, is basically break-even–and that’s after a $600 million search payment from Google that is close to 100% pure profit
- The media business–AOL’s future growth story–currently loses about $600 million a year. This performance will improve radically after the next round of cost cutting. But for AOL to become a growth story again, it will have to restore growth on a cost base that is a third smaller than the current one.
AOL now consists of a subscription business and an advertising business.
AOL’s subscription business, which is mostly the remaining dial-up subscribers, is shrinking at 25%-30% per year. AOL’s advertising business, which consists of AOL media properties, a search deal with Google, and an ad network, is shrinking close to 20% per year.
AOL’s combined operations generated EBITDA (cash flow before capital expenditures) of $239 million in Q3, or a run-rate of about $1 billion a year. The two businesses do not contribute to this EBITDA equally, however.
AOL’s advertising business is now larger than its subscription business, and it should remain so as the subscription business continues to shrink. What most analysts don’t understand, however–and what a source who recently had a look at the numbers tells us–is that the dying subscription business generates NEARLY ALL of the company’s $1 billion of EBITDA. The advertising business–the business that is supposed to represent the company’s future–actually loses money.
Worse, the remaining subscribers to the subscription business generate 25%-50% of the traffic to AOL’s media properties (measured by pageviews and time, not by “uniques”). As these subscribers leave the service, therefore, AOL’s media business faces serious headwinds.
These dynamics have always been a problem for AOL, and they’re the reason the spinoff of just the “access” business never made sense. But now that the company is going public, presumably with a growth story, they’re a real problem.
Here’s a snapshot of the current performance of AOL’s businesses. The revenue numbers are Q3 annualized (and rounded). The EBITDA numbers are round estimates based on our source’s information and the description in AOL’s latest financial filing. (For understandable reasons, AOL is not breaking them out in detail).
AOL Combined (Annualized based on Q3)
Revenue: $3.1 billion, shrinking ~25% per year
EBITDA: $1.0 billion, shrinking ~20%
Revenue: $1.3 billion, shrinking nearly 30% per year
EBITDA: $1.0 billion, shrinking ~25% per year
Revenue: $1.7 billion, shrinking nearly 20% per year
Again, our understanding is that the subscription business generates nearly of the company’s EBITDA and the advertising business breaks even. And it gets worse.
THE SUBSCRIPTION BUSINESS
AOL’s subscription business is shrinking at 25%-30% per year. The costs are largely variable, so AOL should be able to preserve the EBITDA in this business as revenue shrinks. As the business shrinks, however, the EBITDA margin will gradually drop (some of the costs are fixed), so EBITDA will likely decline faster than revenue.
Assuming the subscription business shrinks 25% per year for the next two years, subscription EBITDA will be approximately $800 million in a year and $600 million in two years. At some point, the subscription business will stabilise, but probably at well below $500 million a year.
Meanwhile, the departing subscribers will take a lot of the traffic to the media properties with them. If the subscriber base shrinks by half in the next two years, the 25%-50% of the traffic to AOL’s media properties these folks generate will also shrink by half. So, all else being equal, AOL’s media traffic will likely decline by 12%-25% just from the loss of subscribers (less if the subs retain and frequently use their email accounts, which we suspect most don’t).
THE ADVERTISING BUSINESS
The economics of the advertising business are even worse.
AOL’s advertising business consists of:
- an ad network
- a search partnership (currently with Google)
- AOL media properties
Specifically, based on Q3 numbers (annualized), here’s what we think AOL’s ad business looks like:
AOL Media properties: $600 million a year, shrinking ~20%
AOL Search: $600 million, shrinking
AOL Ad Network: $500 million, shrinking
AOL Advertising Combined: $1.7 billion
The combined advertising business, as we’ve noted, loses a modest amount of money. Buried in the advertising business, moreover, is a ~$600 million-a-year search payment from Google. This search payment is presumably close to 100% profit. This means that the economics of the rest of AOL’s advertising business look something like this:
Revenue: $1.1 billion
Profit: – $600 million
As AOL continues to lose subscribers, moreover, the subscribers will take both search revenue AND advertising revenue with them. The bulk of AOL’s advertising business, therefore–$1.1 billion–is directly affected by the ongoing departure of subscribers. So, all else being equal, the rest of AOL’s advertising business will have to grow very rapidly merely to keep revenue and EBITDA the same.
So, to reiterate, this is what today’s AOL looks like:
- A $1.3 billion subscription business that generates 100% of the company’s profit and is shrinking 25% per year
- A $1.7 billion ad business that loses money and is shrinking 20% per year
- Departing subscribers that contribute 25%-50% of the ad inventory for the media business. All else being equal, traffic from these subscribers is likely shrinking 20%-25% per year.
THE BOTTOM LINE
There’s not much AOL can do about the subscription business other than milk it. If AOL does a good job of of this, it should have $500+ million of EBITDA per year from that business to play with for the next few years.
The advertising business, meanwhile, needs radical cost-cutting–on the order of $300 million per year (2,000 people). There is no way AOL’s media and ad network businesses should be losing $600 million a year between them (ex the Google search payment). AOL will therefore need to rebuild the revenue in these businesses AND cut costs. They’ll have to do this, moreover, in the face of ongoing traffic shrinkages from from the dying subscription business.
Tim Armstrong has his work cut out for him.
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