What is Google's Real Exposure to AOL? (GOOG, TWX, MSFT)

There was intense speculation at end of last week that Microsoft (ticker: MSFT) was in talks to buy AOL from Time Warner (ticker: TWX). After noticing that Google's SEC filings state that Google derived 12% of its 2004 revenue from AOL, others then speculated that Google could bid for AOL. But Citigroup analyst Mark Mahaney shows that Google's exposure to AOL is less than that number suggests. From his note to clients:

GOOG: 2.6% and Declining Net Revenue from AOL Limits Risk

Press reports on Friday indicated that Microsoft was considering acquiring a stake in AOL. Given that Microsoft is aggressively working to compete with Google in the search advertising sector and that AOL has consistently been Google’s largest affiliate partner, the incremental risk is that Google could lose its largest affiliate. Note that Google’s affiliate deal with AOL began in May 2002 and is reportedly set to run through 2011, with annual renegotiation options.

We agree with the incremental risk, but NOT with how it has been quantified. Google has disclosed that AOL accounted for 11% of H1:05 revenue. Key point -- this is 11% of Google's GROSS -- not NET -- revenue. By our estimates, AOL's NET revenue contribution to Google was 2.6% in the June quarter, and has been declining steadily over the past six quarters – from 3.3% in March 2004. Note that we view net revenue as a good proxy for EPS contribution.

We worked back through Google’s filings to develop our quarterly estimates of AOL’s quarterly gross revenue contribution. As quick background, Google generates revenue both from searches on its own Websites and from searches on its affiliate Websites. Revenue from its own Websites drops straight through the P&L, while revenue from its affiliates is first shared with the affiliates. This revenue share is referred to as Traffic Acquisition Costs or TAC, and is disclosed by Google. In the most recent quarter, TAC was 78%, meaning that for every dollar Google generated in gross revenue from its affiliates, it shared $0.78 with the affiliate. This is why the affiliates in 2004 accounted for 50% of Google’s gross revenue, but only 17% of its net revenue.

Google’s TAC with AOL has not been disclosed, but our checks indicate that it is meaningfully above the average affiliate TAC. For the analysis above, we use 85%. And if we’re wrong, it’s because we’re too low. So our 2.6% net revenue contribution may be too high.

We also anticipate that AOL's net revenue contribution will continue to decline as Google grows its own network revenue, its new affiliate revenue, and its revenue from AdSense for Content and other offerings.

We don’t yet have a concrete point of view on the likelihood of an MSFT-AOL joint venture. We’ll start with healthy skepticism that an MSN-AOL joint venture can generate material synergies near-term, but we acknowledge that this development could have a significant long-term impact on the Internet advertising market.

So bottom line -- we view the incremental risk here as limited and declining. We reiterate our Buy recommendation on GOOG and our $375 PT.

Related:

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