New AOL Patents Will Reward Microsoft Investors

| About: Microsoft Corporation (MSFT)

Shares of America Online (AOL), once the premiere Internet service provider, jumped over 40% in recent trading on news of a planned sale of patents to Microsoft (MSFT). The struggling Internet business has entered into an agreement to sell over 800 patents and licenses for $1.06 billion dollars. In the plan, which is still subject to antitrust review, AOL would receive licenses to use the patents sold to Microsoft. AOL said it would return a "significant" portion of the proceeds to its shareholders. The company already has a large sum of cash on hand, about $15 in cash per share at the end of 2011.

The deal is geared to be tax advantageous for AOL. It is planning to sell a subsidiary company at a loss in order to offset taxes from the sale. The company is also planning to use a portion of its current tax deferred assets to offset any future tax liability from the licensing of its remaining patent portfolio.

CEO Armstrong said that the deal will enable AOL "to aggressively execute on our strategy to create long-term share value." The announcement sent the company stock soaring by over 30% and took share prices to a new high. The short ratio was around 15% of the float and could mean a lot of the gain was short covering and repositioning.

AOL will still hold about 300 patents, covering its core business, and will receive licenses for the patents sold to Microsoft. The sales and licensing agreement is meant to unlock shareholder value, but I think the jump in price is really just another chance to short AOL stock.

In a similar statement, Microsoft said that it has been watching the AOL patent portfolio for years and has been "analyzing" it over the past few months. Microsoft said that it had achieved two goals with the purchase: the acquired a "durable" license to the AOL portfolio and ownership of patents that "compliment" Microsoft's current portfolio.

AOL has been struggling ever since it was spun off by its former parent, Time Warner (NYSE:TWX). In it's most recent earnings report for Q4 2011, released this past February, AOL posted a 22% decline in revenue. The decline was mostly in subscription services but was offset by a 2% increase in advertising. Operating income, cash from operations, and free cash flow all declined roughly 50% for the 2011 period. One of the listed highlights of the report was that Q4 2011 marked the lowest revenue decline in five years and was not inspiring to investors. AOL will continue its struggle with revenue and earnings, especially since it has been experiencing an increase in costs. Some of the cost increases are due to restructuring and a shift of business focus.

Microsoft will emerge from this deal much stronger than AOL. The addition of the new patents will strengthen Microsoft's position against its competitors, like Apple (AAPL). Microsoft has a history of positive earnings and earnings growth, recently setting a quarterly revenue record. Estimates for the current year are in line with last year's results, but could be positively impacted by the recent news if the deal closes smoothly. Microsoft is a much better choice to ride out this new deal. First, the deal is subject to a number of regulatory approvals and may not move forward as announced. Second, AOL's trouble with subscription revenue will not be erased by selling its patents. The Internet service provider competes with a number of other companies.

For instance, Yahoo (YHOO) moved up recently and is in the middle of its three-year trading range. Yahoo does not have the same problems with profitability as AOL; the company has a history of positive earnings and expectations of future growth despite recent declines in revenue. The stock is valued about 18 times earnings, trading around $15.

Charter (CHTR) is a leading provider of Internet, cable TV, and phone services. The company reported another net loss last year, but marked an increase in revenue. The multitiered information and communication company has been struggling in many of its segments, but has made some significant increases in its footprint and revenue from Internet and commercial services. While Charter and AOL are not direct competitors, they do operate in much of the same space and they both lack the strength of Microsoft in terms of business model, revenue, and profitability. It is far more likely that companies like AOL and Charter will be scooped up by the established giants in the Internet technology sector, like Microsoft. That is basically what Microsoft is doing. It just became the owner and licensed user for 1,100 of AOL's patents and now can use any part of AOL's technology it wants and compete it out of business. And Microsoft did it at a fraction of the current market price.

Microsoft traded down on the news, despite the obvious advantages. The economic outlook for 2012 will keep its share price in check temporarily, but the trend is still up. Microsoft needs to incorporate AOL's unique software into its online arsenal to enhance its online presence as a search engine and source of information and social media. If Microsoft can accomplish this successfully it will gain a new foothold on the future of Internet technology. Microsoft is the clear winner in this deal. AOL will get some more cash and boost shareholder value, but that will be short-lived. AOL needs to see some real organic growth or other type of market leadership in order to maintain the new highs. Microsoft has gained a better position to evolve with the Internet technology industry.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

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