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Well, yesterday was exciting, wasn’t it?AOL agreed to buy the Huffington Post for $315 million and hire Arianna Huffington to revolutionise its content business.
And it did this just after releasing a huge MBA-style document on how to make money on content called The AOL Way.
Talk about enormous changes!
But that was yesterday. Now the fun’s over. And it’s time to talk through the reality of the situation.
The reality of the situation is this:
- More than half of AOL’s revenue and all of its profit (our estimate) come from two dying businesses: dial-up Internet access and search.
- These two businesses are shrinking at 20+% per year.
Now, no one cares about these businesses or gives them a moment’s thought. But, again, they’re likely producing all of AOL’s profit. And that means that the core business, the one that AOL is asking investors to bet on, is still in lousy shape.
What is this core business?
Yes, AOL also has an ad-network called Advertising.com that still generates $350 million of revenue a year. But that’s a low-margin business, and it’s shrinking at a startling 40%+ per year. So let’s ignore it. (AOL should just sell this business and use the proceeds to buy more premium content businesses).
As of Q4, AOL’s content business looked something like this:
$600 million of revenue (annualized), shrinking 8% per year.
Our analysis (which we’ll detail in a forthcoming post) suggests that AOL’s content business is at best break-even and, more likely, is losing money. If this business is to become AOL’s primary profit growth engine in future years, therefore, it will have to be radically restructured.
Specifically, it will have to have enough cost cut out of it to produce a pre-tax profit margin of a respectable 20%.How much cost is that?
Assuming the business is currently break-even, and assuming revenue doesn’t shrink further (it will), AOL needs to cut at least $120 million of cost out of this business. It will then need to begin to grow the revenue of the business by, say, 20% per year.
Now, cutting 20% of the costs out of a $600 million business, stopping the revenue declines, and then accelerating revenue growth to 20% a year is no mean feat.
This is especially true because AOL’s content business likely has at least 2,000 employees toiling away on dozens of different projects and brands.
Yes, these employees have recently been reorganized into “towns,” but they’re going to have to be reorganized far more than that. And at least 1 in 5 of them will likely have to leave the company.
2,000 employees, by the way, is about 10X as many employees as work at the Huffington Post.
So, Arianna has her work cut out for her!
Specifically, Arianna is going to need to hire a team of executives with serious turnaround experience–executives who can get the cost structure of AOL’s content business in shape, figure out a cohesive strategy in which all the individual brands serve the company’s content mission, and then get the display-ad revenue growth engine cranking again.
Assuming Arianna can pull this off–and, if she can, she will be able to take her place in the pantheon of legendary managers–what will this business look like?
Here are some back-of-the-envelope projections:
2011 REVENUE: $600 million
2011 OPERATING PROFIT: $100 million (17% margin, assumes radical cost cuts in Q2)
2012 REVENUE: $720 million (+20%)
2012 OPERATING PROFIT: $144 million (20% margin, up 25%, +$44 million)
2013 REVENUE: $865 million (+20%)
2013 OPERATING PROFIT: $170 million (20% margin, up 20%, +$35 million)
Will AOL’s content business grow like that? We doubt it. But let’s give Arianna the benefit of the doubt.
If AOL’s content business grows like that, what will happen to the overall company’s operating profit?
Unfortunately, it will continue to decline, unless AOL cuts vastly more costs out of the business.
Because, right now, AOL’s operating profit is declining by 20%+ per year, or $200 million. The content business growth that we penciled in above would offset that decline to some extent, but it wouldn’t turn it into growth.
(In the above scenario, AOL’s content business would add $100 million of annualized profit from the initial cost cut, then $44 million of growth the following year and $35 million in the year after that. Even if you took all that growth in a single year and repeated it every year, it wouldn’t offset the $200 million profit shrinkage per year AOL is currently experiencing).
So, for AOL to ever grow operating profit again, not only does the content business have to perform as outlined above, the two dying businesses–search and dial-up–have to stabilise quickly. And there’s almost no chance of that happening.
BUT HERE’S THE GOOD NEWS…
The good news is that AOL’s content business, if it can get its act together, can be a very valuable business all on its own.
Demand Media, a public comparable company that is partially in the content business, is currently trading at about 6X-7X trailing 12-month revenue of about $250 million.
Demand Media is growing, which AOL’s content business currently isn’t. But for the sake of argument, let’s assume AOL can get its content business growing again, in the way we outlined above.In that scenario, AOL’s content business alone could be worth 6X-7X revenue, or $3.6 billion-$4 billion on the $600 million of revenue. To be conservative, though, let’s say AOL’s content business will never achieve even a Demand-Media-like valuation (*shudder*), and assume that AOL’s content business will only trade at 5X revenue. That’s still $3 billion.
Right now, AOL is trading at a $2 billion valuation.
That means the market is assuming that AOL will NEVER get its content business headed in the right direction. (It might). It also means the market is assuming that AOL’s two dying businesses, search and dial-up, won’t continue to pump out hundreds of millions of dollars of cash over the next several years while they die. (They will.)
And that means there actually is an upside scenario here for the stock and company even if the search and dial-up businesses continue to die. (They will).
WHAT AOL SHOULD DO
By the way, the best strategy for AOL going forward is revealed by the analysis above.
AOL should quickly sell Advertising.com, MapQuest, and any other properties that don’t serve the content business, isolate the dial-up and search businesses in a separate part of the P&L, and focus all of its efforts on the content business. It should break out the performance of this business–top and bottom lines–and focus on growing both revenue and profits. And it should make sure investors and employees are focused on the progress of the content business.
Then, because scale is a huge advantage here, AOL should keep re-investing the cash produced by the dying business in new content brands it can bolt onto its ad sales and technology infrastructure.
By doing this–and only this–AOL has a path to building the content company for the 21st Century, which, if memory serves, is what Tim Armstrong wanted to build.
So get to work, Arianna!
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