Sell-Side Reaction to the Google-AOL Deal (GOOG, MSFT, TWX)

Citigroup analyst Mark Mahaney commented on Google's deal to purchase 5% of AOL from Time Warner; here's an extract from his note to clients:

SUMMARY

• Reports indicate that GOOG and AOL are close to a deal wherein their search advertising relationship will extend for 5 years, their overall advertising partnership will deepen, and GOOG will invest $1B for a 5% stake.
• The negatives here are that GOOG has likely had to make a sizeable cash commitment to maintain the AOL partnership, and the search advertising extension may be on terms less favorable than before. The compensating positives are that GOOG appears to have secured AOL vs. a competing offer from Microsoft -- maintaining part of its scale advantage in the sector -- and the new partnership may give GOOG greater inroads into display advertising.
• Given our view that the market has been more focused on the MSFT threat and that GOOG's dependence on AOL is limited -- 2% or less of its net revenue -- we believe the reported deal would be a modest positive for GOOG. We reiterate our Buy and our $490 PT on GOOG.

OPINION

We’ll do a full analysis if and when all the details are in. But we’ll make a few quick points here:

$1B is a lot of cash, but it represents 13%of GOOG’s total position –As of September, Google had $7.6B in net cash, equivalents, and investments ($26 per share). And we anticipate Google generating $300MM in FCF in the December quarter and $2.2B in 2006. One obvious question is whether the reported $1B for a 5% stake in AOL is a reasonable investment for Google. For now, we’ll duck the question and will wait for further details before making that call...

The MSFT competitive angle is key here – Our sense is that the market has been highly focused on the possibility that Microsoft would successfully negotiate to replace Google as AOL’s search engine. Were the reported AOL Google deal to be concluded, we believe it would be a positive competitive development for Google as it would maintain its scale advantage over its two major search engine competitors – Yahoo! and MSN. (We note that AOL’s properties account for approximately 10% of all U.S. searches.) We believe there may be another positive competitive implication here for Google, however. Per our recent channel checks and product comparisons (See our December 8th note, “Increased Conviction in Google