A lot of Web 1.0's old guard has long since shuffled off their mortal coil into the great company graveyard where many businesses, particularly in the tech sector, invariably come to a final rest. AOL (NYSE:AOL), a name synonymous with the virtues and vices of the dot-com bubble, is somehow still around and perhaps stronger than ever. The recent trends in the business would suggest an emerging growth company that may have recently been a start-up, not an aged (albeit leaner) mid-cap that should perhaps be puttering along at GDP-like levels. The truth is that AOL is, for all practical purposes, a new company today; its ad tech platform AOL ONE is the confluence of a transformative 'start-up like' effort that has been more than four years in the making. Since 2010, AOL has spent roughly $800 million, or a quarter of today's $3 billion market cap, to retool its old ad networks segment into a programmatic tech stack that is articulated across both display and (critically) video channels of advertising.
Source: SEC filings
The ad tech industry in recent years has started to resemble New York's subway at rush hour; a teeming crowd of businesses availing themselves of whatever spot remains, sometimes in uncomfortable feats of squeezing and contortion. For followers of the industry, there is an infamous slide by Luma Partners3 reproduced below that underscores the complexity of what in essence is simple demand and supply. Said differently, there are marketers/advertisers on the demand-side and consumers/publishers on the supply-side, with a whole lot of (sometimes questionable) in-between.
Source: Luma Partners
The issue has been that getting from point (A)dvertiser to (P)ublisher has almost been like reciting the alphabet, going through the Bs, Cs, Ds, right through the Ms, Ns, Os, to get to the other side. Industry proponents of end-to-end solutions have called the excessive nodal intermediation a tech tax, in that middlemen have often eroded the value proposition of each dollar changing hands between end participants4. While point solutions are necessary, particularly among businesses that lack the effective capital to in-source all functions of the stack, AOL is betting on automation begetting integration, with programmatic ad tech expected to become the de facto method of marketing across most (if not all) channels. The thesis is that positive network effects will augment the value proposition of bringing a single comprehensive solution to bear on future marketing business. AOL sought to put proof to this point by simultaneously disclosing its launch of ONE with the announcement that $8 billion large cap behemoth Interpublic Group (NYSE:IPG) was signed on as the first ad agency to use the full platform.
At Cowen's recent tech investor conference, AOL's investor relations team addressed, among other things, recent deal pipeline and the general outlook for ONE. The acquisitive contribution of its largest addition to ONE, Adap.TV, was meaningful, on the order of 24% of a total 43% segment growth number year-on-year. That still leaves a substantial order of magnitude impact from organic business that is in itself largely the culmination of prior acquisitions. However, Adap addresses the crown jewel of online marketing channels, i.e. video. The opportunity set is so lucrative - digital video ad spending increased 45% to $4 billion in 2013 and is expected to increase to $5.89 billion in 2014 - that the likes of Microsoft (NASDAQ:MSFT) are willing to 'play nice' in a distribution deal that allows video content from AOL brands to be available on MSN and Bing apps.
Detractors argue that such very actions might stifle the end-to-end ad tech business model because ultimate participants and users will abscond from the possibility of AOL or others forcing their content into the funnel ahead or in lieu of others in the stack. Numbers suggest otherwise: the AOL platforms segment reported $744 million in 2013 revenue and $615 million from third party network advertising revenue, implying that some $130 million or 17% of the segment was based on AOL content. In Q1'14, that contribution was up slightly to 19%, but 2012 was 21%. There is no definitive upward trend and the IR team made the point clear at the recent Cowen conference that the new programmatic tech is proactively cannibalizing third party traditional network media.
In general, the early investment dollars into ONE appear to be bearing fruit on the top-line with Q1 run-rate revenue of roughly $920 million on the reported Platforms segment. Management anticipates that high single-digit OIBDA margins should only be the first threshold to potentially greater upside. Indeed, recent acquisitions have followed the Q1 numbers into a new previously untapped area of profitability for ONE, i.e. subscriptions.
Convertro is the next order/gen premiumization of AOL ONE. It is a SaaS asset that sits at the pure tech stream far away from traditional network media solutions. It was the first key acquisition of the post-ONE era, and at once represented integration across the programmatic parts as well as extension of the end-to-end model. SaaS assets like Convertro can be expected to demonstrate superior margin on contractual business with recurring revenue and a strong ability to cross-sell. Indeed, management believes that Convertro is the next door opening to "potentially a number of revenue streams which kind of span from percent of media to managed services fee to licensing fees."
Assuming ONE is roughly a $1 billion business today with 10% OIBDA margin growing on average 14%, quick back-of-the-envelope suggests it could be a $2 billion business in five years. Assuming no margin expansion, the path to $200 million of OIBDA in five years suggests a payback on investment in acquisitions by the fourth year. In truth, the timetable is probably closer to half that because it is hard to envision no margin expansion in a business that is moving further toward tech and which has yet to ramp up its newest SaaS asset.
AOL will tell investors that ONE is the only true end-to-end platform of note, but we believe the barrier to entry for this business model is less of size/scale, and more of scope. Adaptive Medias (OTCQB:ADTMD) is crafting a similar end-to-end solution with relatively less capital intensity at the lower end of the market cap spectrum. Where AOL ONE has 5Min and goviral for video syndication and distribution, Adaptive has its recently on-boarded MediaGraph assets. Where ONE has Adap.TV for its programmatic video stack, Adaptive has Ember. On an equivalence basis, AOL spent $800 million in acquisitions to add roughly $410 million5 in annual third party network ad revenue6 at roughly 2x, whereas Adaptive's pro forma stack at 1.7x reflects about $17MM of invested capital for about $10MM in run-rate revenue7. The comparison is not exact (e.g. ONE has Convertro's SaaS attribution model, which Adaptive does not), but there is an instructive precedent for understanding where and how nimble operators can remain disruptive in spite of the relative lack of scale. One final caveat in favor of the Adaptives of the world would be that publishers value choice. While acknowledging the obvious value of an end-to-end stack, they may eschew the larger provider, who may limit content choice or fill the funnel with some of their own content, in favor of the smaller operator, ceteris paribus.
In both cases, the gauntlet has been thrown down against the current marketing landscape and we believe there is a very interesting and exciting period ahead for industry consolidation and reconfiguration. Invariably, some of the fervor has tempered as point solution names like FUEL (demand-side platform) have lost some of their sheen in recent weeks as the market uncomfortably digested significantly lower earnings guidance. However, we believe that the end-to-end model can provide a steadying effect during the expected growth acceleration of programmatic and video advertising over the next few years.
3 One of programmatic company Rocket Fuel's (NASDAQ:FUEL) IPO underwriters
4 We have seen the operative data point as being roughly $0.40 of every marketer dollar reaching the publisher
5 Q1 amount was $187 million, which annualizes to $748 million vs. $336 million in 2010
6 We use third party network revenue as opposed to the entire platform segment revenue to ensure an apples-to-apples comparison to Adaptive, which does not have its own content
7 7MM shares for Ember acquisition at $0.09 (pre-reverse split) plus 5MM shares for MediaGraph assets at $2.75 (post-reverse split), plus 33.5MM for Adaptive reverse merger at $0.075, for a total of ~$17MM. MediaGraph is projected to deliver $7MM in 2014 revenue and Adaptive/Ember Q1 was $730K, which annualizes to about $3MM
Disclosure: The author is long ADTMD.
Business relationship disclosure: The article has been written by one of William Nichols & Associates’ investment associates. William Nichols & Associates is not receiving compensation for it. William Nichols & Associates has no business relationship with any company whose stock is mentioned in this article.