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AOL’s (NYSE:AOL) efforts to streamline and consolidate its businesses have translated to revenue gains for its global advertising business for the first time since 2008; however overall profitability is still a concern and its much needed boost in ad revenues fell short of many analysts expectations. [1] The is what led its shares to a 40+% slide in the last few days as AOL’s earnings and outlook provided little in the way of comfort for those waiting for CEO Tim Armstrong to deliver the much anticipated ad growth signaling its turn around. AOL competes with other search and display ad giants such as Google (NASDAQ:GOOG), Facebook and Yahoo (NASDAQ:YHOO) but is losing ground to these players on most metrics.

We have a revised price estimate of $14 for AOL stock, which is about 25% above the current market price. We have downgraded our estimates considerably mainly due to concerns over AOL’s reduced gross margin for 2011, which affected our profitability estimates. The revised price also reflects changes to the company’s net cash/debt position.

New Products & Acquisitions Should Drive Display Ad Growth

Given its recent acquisitions such as Huffington Post as well as AOL’s third-party initiatives such as the Editions Magazine App, [2] display ads will increasingly occupy a bulk of AOL’s revenue while its search and subscription businesses are being gobbled up by competition.

With its subscription business becoming obsolete and search ads succumbing to competition, AOL’s strategy is increasingly veering toward building its display ads business on its own sites as well as third parties.

The 16% YoY (year-on-year) growth in U.S. display revenues for Q2 2011 is directly related to higher traffic and page views acquired through The Huffington Post, which recently surpassed New York Times in terms of monthly unique visitors. [3]

Strategic acquisitions such as Huffington Post and Patch should continue to drive traffic to AOL sites. Additionally, AOL’s Project Devil metrics have been encouraging with AOL seeing 6.4x higher engagement through Project Devil ads as compared to standard ones. [4]

(Chart created using Trefis' app)

Profitability is a Concern

Despite the display ad growth, reaching profitability can still be a lingering concern for AOL. Gross margins for AOL (excluding depreciation & amortization) reduced to around 34% for the first half of 2011, compared with around 51% for the same period last year. [5] This clearly suggests that AOL’s acquisition spree is coming at a price as the company incurred higher personnel costs due to additional investments in Patch and other acquisitions made in Q1 2011. The outlook is murky as well as increasing competition in the display ad market can drive traffic acquisition costs higher.

Notes:

  1. Seeking Alpha: AOL’s CEO Discusses Q2 2011 Results – Earnings Call Transcript
  2. AOL Launches Daily “Magazine” App
  3. Huffington Post Traffic Surpasses NYTimes.com
  4. TechCrunch: Tim Armstrong Gives Some Project Devil Details
  5. AOL Investor Relations: Q2 2011 Earnings Release

Disclosure: No positions

Source: Display Ads Provide Some Hope for AOL in Otherwise Disappointing Outlook