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AOL-Google: Who Gets What

After a year of negotiations, Time Warner (TWX) and Google (GOOG) have finally gone public with a pact that gives Google a 5% stake in America Online in exchange for $1 billion. The alliance is designed to shore up the business prospects of AOL, Time Warner's giant Internet unit, but it may end up being a bigger boon for Google.

The deal includes a wide range of business and technology agreements that are designed to put AOL back into the vanguard of Web companies. AOL became the dominant online force after it emerged 20 years ago. Its influence peaked in 2000, when it merged with Time Warner at the height of the dot-com bubble.

LOST EDGE. Time Warner shares have sunk from $100 to a current $17.74, in part because the merger failed to live up to management's promises. The number of AOL subscribers has declined to 20 million from a peak of 26 million. And after prevailing in the era of slow dial-up Internet connections, AOL has never maintained a lead in the broadband era. It lost its edge to leaders such as fast-growing Google, which went public just over a year ago. Google is already worth more than Time Warner itself, even though Time Warner has nearly nine times more revenue than Google.

AOL has tried to remake itself as a free portal, in the mold of Yahoo! (YHOO) and Google. The AOL free site has 110 million unique visitors a month, making it the second-largest network after Yahoo. It also has had some successes on its redesigned platform, notably the Webcast of the Live 8 music benefit earlier this year.

The new Google pact is intended to take the AOL overhaul to the next level. That's particularly true in the advertising market, where AOL's margins lag behind those of Google and Yahoo. Google already provides search technology to AOL. As part of the latest deal, Google will allow AOL and other companies to place display ads on Google pages.

BATTLING ICAHN. That's a sharp change for Google, which has restricted itself to small text ads and the sale of prominent ad placement for businesses that want to be associated with relevant searches. Google will give AOL a credit of $300 million that can be used to purchase ads that are auctioned off to advertisers. That will help boost traffic on the AOL network, allowing it to charge higher ad rates and boost its margins.

Another side benefit: Time Warner Chief Executive Richard Parsons ostensibly could use the Google agreement to beat back efforts to break apart his company by billionaire Carl Icahn and allies, who control about 3% of the shares. Icahn warned in a letter that it would be "disastrous" if Time Warner did a Google alliance that made it harder to proceed with subsequent deals that would boost the value of Time Warner's shares, which have languished for years (see BW Online, 12/19/05, "Time Warner: Still Searching for Answers").

But one investor indicated that it wasn't clear whether the deal would impede such plans. Google is investing $1 billion in an agreement that values AOL at $20 billion. Google has certain "customary" minority shareholder rights, but those rights haven't been spelled out. While Google doesn't have a say in the operation of AOL's business, Google's interests would have to be considered if AOL were sold, a Time Warner executive says.

TINKERING WITH ADS. It also wasn't clear whether the financial terms of the three-year-old search agreement would change. In the past, Time Warner has kept 80% of its search revenue and given 20% to Google. AOL has wanted to hold on to more revenue. The deal's full details may never be known, making it difficult to fully understand its impact on a potential breakup of Time Warner, according to the investor.

The biggest winner may end up being Google. Assuming the new display ads don't damage the Google brand, they could be a good idea. It has been tinkering with display ads for several months, putting ads with images on its partners' sites. That hasn't enticed many marketers, because they want to show up on the important real estate -- next to Google's search results.

Introducing such ads on its own pages could be a massive source of growth for Google, helping to justify its $429 stock price (see BW Online, 11/18/05, "Is Google Flying Too High?"). Researcher eMarketer says U.S. spending for display ads in 2005 will reach $2.3 billion, nearly half the size of the $5.4 billion market for search ads. That's a big, untapped opportunity for Google -- and something that key competitor Yahoo is already doing with success. In its most recent quarter, analysts estimate that Yahoo generated about $330 million in display ads, nearly 40% of its booming search business of roughly $830 million.

MICROSOFT'S PROSPECTS. Furthermore, display ads would open up Google to a whole new breed of online advertiser, including companies like General Mills (GIS), Ford (F), and General Motors (GM), which often advertise to build brand as much as to sell goods. Display ads are more effective at brand building than the simple text ads, which usually consist of about 10 words or so.

Under the new agreement, the global advertising partnership between AOL and Google, known as the AOL Marketplace, will expand. Time Warner will be able to sell Google search tools to advertisers under its own name. Google will help AOL figure out how to improve the placement of its pages when customers perform searches on Google. And Google Talk, the instant-messaging platform, will become compatible with AOL's AIM, the market leader in instant messaging. The companies also will collaborate on video search, which will help increase consumer awareness of Time Warner-AOL video content on the Web.

The alliance could also give Google a leg up in its perennial battle with Microsoft (MSFT). Microsoft also had been vying for a partnership with AOL, and for a while, some analysts reckoned that Microsoft had a strong chance of pushing aside rival Google (see BW Online, 11/7/05, "The Stakes in the Fight for AOL"). Now, Microsoft must find other ways to boost the prospects of its MSN Internet network, which lags behind competitors Google and Yahoo in some important respects, such as the paid search business.

"NOT FOR SALE." It remains uncertain whether the new pact will help Time Warner CEO Parsons hold the company together and keep his job. Meeting with reporters in recent days, he insisted that "AOL is most definitely not for sale, and its value is coming on strong. Other companies are starting to see the same value in AOL that we knew was there all along."

If nothing else, the Time Warner chief has a little breathing room to make that value apparent. And don't be surprised if the deal does a little to enhance Google's already-lofty value as well.

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