Buy AOL and Hedge With This Stock
David is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.
If you are interested in buying shares of a media advertising business, I recommend looking at turnaround plays and hedging with more diversified picks. Investors should look particularly at the media platform's future in mobile and whether it is taking the right steps to be relevant in the smartphone age. Below, I review two key stocks with this focus in mind.
Why You Should Buy AOL (NYSE: AOL)
AOL's comeback story has almost come entirely out of left field. This global web service firm provides Internet access and runs ads on its media properties. These "properties" include DailyFinance, TechCrunch, Moviefone, Joystiq, and The Huffington Post. The stock has nearly doubled to around $30, and it still trades 10% under book value and at 6.8x cash flow versus 5.2x and 17.6x for the consensus average. On the other hand, it is not generating a meaningful amount of return on invested capital, which means value is not being created. 8 of 12 reporting analysts rate the stock a "hold".
There are several variables to consider before buying stock in AOL. The company recently bought out Buysight that retargets a prospective lead with ads after s/he has left a site is an innovative form of advertising that complements AOL's Advertising.com business. This asset was particularly highlighted in the third quarter earnings call for its consistency in sequential growth. Investors are also largely focused on that terrific third quarter where EPS of $0.22 beat expectations by 5 cents and gross margins expanded 270 bps sequentially despite the shift towards mobile Internet use--comScore estimates that 42% of September unique domestic viewers relied on mobile and 12% relied exclusively on it. Moroever, search & contextual ad sales grew by 8%--the first increase in 3 years! Further, the company is taking meaningful steps to address this mobile world. It launch of an email service that aggregates AOL, Yahoo, Gmail, and iCloud mail & messages into one inbox has garnered rave reviews for its touchscreen-friendliness. The relaunch of Games.com is well timed, as is AOL's video library that served 664 million videos to almost 40 million unique domestic viewers in just July.
I further believe that AOL is a much stronger investment than its <$1 billion peers. Demand Media (NYSE: DMD)) fell 7.3% in early December off of a downgrade to "sell" that stressed greater ad expenses resulting from keyword competition in Google. Demand Media's brands, eHow, Cracked.com, Livestrong.com, Daily Puppy, etc., have been likened to web spam and have a limited growth prospects. At 20.6x forward earnings, much of the upside has already been factored into the stock price. Analysts have been tepid about the stock, and, with shares up 65.3% from the 52-week high, positive catalysts are largely absent compared to AOL, which offers diversified media solutions for advertising.
Hedge With Google (NASDAQ: GOOG)
With so much risk going into AOL, you should hedge your bets with a safer investment in Google. Both will benefit from growing demand for mobile Internet, but Google is particularly well positioned with 75% of mobile US and plans to release its own phone, dubbed the "X Phone". It controls the largest online video distributor in the world, YouTube, and also the most popular email service, Gmail. It has succeeded time and time again in monetizing its platforms beyond the core search ad business we known on Google.com.
At 22.2x past earnings, the company may seem expensive, but the firm has $45.7 billion in cash with little to no debt. The consensus price target is still around $800, which means the stock has more than a 10%+ premium. Assuming Google meets expectations, 2016 EPS will come out to $71.91, which, at a multiple of 18x, translates to a future stock value of $1,300. Discounting backwards by 10% yields a present value that is more or less in-line with the consensus price target.
Growth can help a company edge out competition, which Google has been doing in Android (growing faster than the market); but, if it is not accompanied with a return on invested capital that exceeds the cost of that capital, the company is essentially burning shareholder's cash in the short-term. The best kind of growth is that which is accompanied by high returns on invested capital, which Google provides at 17.5%--300 bps greater than the industry average.
To be sure, Google's main problem comes in monetizing Android. The mobile operating system has been called a "charity", although I am hopeful that the X Phone will change this tone. Apple's iOs devices have seen more use in terms of ad clicking, as evidenced by its 63% share of the tracked impression market. This is 4.2x the share you would expect based on the company's smartphone OS share. Although 700,000 Android devices are being activated per day as of December 2012, this is a marked deceleration from the previous 1.3 million/day rate. Android will have to do more with less, and, if AOL's success is of any indication, this is definitely possible.
TakeoverAnalyst has no positions in the stocks mentioned above. The Motley Fool owns shares of Google. Motley Fool newsletter services recommend Google. 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. Is this post wrong? Click here. Think you can do better? Join us and write your own!