Investopedia Advisor submits: Time Warner’s (TWX) board of directors will meet soon to approve a big strategy shift at Internet subsidiary AOL. Rather than pleading with subscribers to stay with the $25 service, AOL will give them the service for free and try to make money from advertisers.
At first glance, it sounds crazy. Since the plan was first leaked, Time Warner’s share value has dropped by 10%. Investors panicked about the short-term pain brought on by the new business model. According to reports in the Wall Street Journal, Time Warner could lose $2 billion in revenue as a result of the shake-up.
No, Time Warner hasn’t lost its mind – just its short-term mindset. Longer-term, the plan makes sense for shareholders.
Sure, the new business model will mean a big cut in subscription revenues. But, in any event, those revenues are vanishing. AOL’s subscriber count dropped by 835,000 or 4% in the latest quarter. Subscription fees revenues fell by 13% even though AOL upped fees by $2.00 per month.
Let’s say the strategic move speeds-up the loss of $2 billion in subscriber revenues, which produce operating profit margins of about 17%. That would translate into $269 million in lost operating profit for Time Warner next year.
At first glance, that looks like a lot to give up – but less so when you consider that those profits are going to evaporate anyway.
With revenues and profits steadily slipping away, AOL’s subscription business is a low value one, akin to telecom operators’ shrinking voice telephony businesses. Valued at 8 times operating profit – the same multiple given to telecom giant AT&T (T) – AOL’s subscription business might be worth about $2.2 billion.
AOL’s job is to make up for lost subscriber fees with advertising revenues, which are higher margin, faster growing and more highly valued by the market. Yahoo! (YHOO), for example, trades at 35 times operating profit. Of course, AOL is no Yahoo!, but assuming AOL trades at a discounted multiple of 25, the Internet portal would need to generate an additional $88 million in advertising profit to hold its current value. At 30% margins, that amounts to about $293 million in new revenue to capture.
That’s quite a leap, but by no means an impossible one. Since 2004, ad sales have grown by an impressive 25-30% per year. With 18.5 million users, AOL remains one of the most popular spots on the ’Net. AOL’s household name brand status together with Time Warner’s vast and valuable storehouse of entertainment could be employed to push up page views and revenue growth.
Of course, AOL will never receive a Yahoo!-like multiple until its cut loose from Time Warner’s unwieldy empire. For the plan to succeed, Time Warner will need to think about a spin-off or sale of AOL. Indeed, AOL could fetch a hefty price for Time Warner.
In the short-term, shareholders won’t get off easy. They should be prepared to brace for losses. But the plan is clear headed.
By Ben McClure, Contributor - Investopedia Advisor