Everyone Does Realize This Was Not a Good Quarter Right?
Chad is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.
I'll admit that my family used to be avid AOL (NYSE: AOL) subscribers. We originally tried out the service in the 1990s, and believe it or not, part of my family still maintained their subscription service up until several months ago. However, just like many people, we realized that the service's value wasn't worth the cost. That's sort of a summary of the AOL subscription service, in my opinion it will eventually go away completely. With AOL reporting earnings recently, I honestly don't understand what investors are thinking bidding up the stock to its current level.
Licensing Made This Quarter:
The company's most recent quarter could be best summed up with one word and that is licensing. Without AOL's agreement with Microsoft (NASDAQ: MSFT), the company would have reported about a $71 million loss as opposed to the over $1 billion worth of earnings that were reported. With total revenue down 2% and real EPS growth nonexistent, there still isn't a whole lot to like about AOL. The company operates in two segments: global advertising and subscription services. Let's take a look at each division and you'll see that one piece is the company's future, the other piece is a slowly dying business.
The Future – Global Advertising:
With total revenue up 6% primarily from international growth, the numbers aren't fantastic, but at least they are positive. In fact, as the company grows its international division, results for this unit should improve. The problem is, domestic display growth represents over 90% of revenue and did not grow at all. International display grew by 21%, but was only 10% of revenues. A big piece challenge for the company is to make AOL search relevant. With unique visitors up 5%, search and contextual revenue still declined by 1%. In addition, AOL's traffic acquisition cost increased by over 14%. By contrast, Google (NASDAQ: GOOG) has been posting paid click growth of better than 30% in each of the last three quarters, and has maintained traffic acquisition costs at around 25% of revenue. The bottom line is, the company still has quite a bit of work to do.
Slow Fade – Subscription Service:
With a revenue decline of 13% and a 12% decline in number of subscribers, it's only a matter of time until this division disappears or is sold. The subscription model is essentially broken as a company still believes they can charge premium prices for non-premium content. Given that Google and Yahoo! (NASDAQ: YHOO) offer much of the same content, the company's software does not provide the unique experience that it once did. In addition, NetZero, which is a division of United Online (NASDAQ: UNTD) offers consumers the ability to use dial-up access at a much lower price point. Once customers realize they can get the same content without the software or higher price, justifying the subscription cost becomes difficult. AOL subscription is caught between lower-priced alternatives and the growing popularity of high-speed Internet.
Great Deal From Microsoft – But This Doesn't Change The Company's Main Problem:
The first step is, the company expects to repurchase about $400 million worth of outstanding shares, representing 14% to 16% of the current share count. While short-term this will help EPS and the relative value of the remaining shares, this is not a long-term solution to AOL's biggest issue. The company's biggest problem is that AOL does not register as a primary Internet destination. An additional major issue is the company's current valuation relative to their competition.
The Valuation Doesn't Make Much Sense:
At current prices, AOL sells for a P/E ratio of 27.73 using 2013 estimates. For a company expected to grow EPS at about 15%, this is a significant premium. In the current quarter, the company still would have posted a loss without the Microsoft deal, this may cause investors to question whether 15% EPS growth is realistic. A better investment opportunity is likely the main competitor that AOL is chasing. Google is the unquestioned search leader in the United States, has maintained dominant market share, and produces significant free cash flow. Considering that investors can buy Google stock for just over half of the forward P/E ratio of AOL, the choice between the two companies seems obvious. Google is also expected to grow earnings at over 15%, but with paid clicks consistently increasing by 30%+, the company could beat expectations. Even Yahoo! could be considered a better opportunity than AOL. Yahoo sells for a similar P/E ratio to Google, but is expected to grow at over 12%. On a relative basis this would seem to be a better value than AOL. It seems that investors have lost sight of the primary issue facing AOL and that is their properties are much less visited than their competition. With huge challenges facing their display properties, and a slowly dying subscription service, the company will have trouble producing significant earnings growth. Given these factors, this is not a company I would be willing to pay almost 28 times earnings for.
MHenage has no positions in the stocks mentioned above. The Motley Fool owns shares of Google and Microsoft. Motley Fool newsletter services recommend Google and Yahoo!. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.If you have questions about this post or the Fool’s blog network, click here for information.