Why Private Equity May Dial Up AOL

The struggling Internet pioneer still generates a lot of cash

For a private equity firm looking for the cheapest way to get online, AOL shares may be a bargain. The Internet pioneer spun off from Time Warner in 2009 plunged to a record low of $10.22 on Aug. 10 after cutting this year’s profit forecast because of slowing growth in display advertising sales on its niche content websites. The stock then jumped 8.9 percent on Aug. 25 after AOL announced it had retained investment bank Allen & Co. and law firm Wachtell, Lipton, Rosen & Katz as advisers. “I have no doubt,” says Michael Holland, chairman of money manager Holland & Co., which oversees more than $4 billion, “that private equity buyers are currently looking.” Graham James, a spokesman for New York-based AOL, confirmed the hiring of the firms and declined to comment further.

Even after its recent spike, as of Aug. 30, AOL traded at 71¢ on the dollar on the basis of book value, or its assets minus liabilities. That makes AOL cheaper than the 46 other U.S. Internet companies that have market values greater than $500 million, data compiled by Bloomberg show.

AOL has posted cumulative net losses of $788 million as a stand-alone company. While its dial-up Internet service generated 39 percent of AOL’s total revenues in the most recent quarter, it has been shrinking. Chief Executive Officer Tim Armstrong, 40, is banking on display ad sales on the Huffington Post, TechCrunch, MapQuest, and Patch’s local community news websites to help the company’s advertising business reach profitability before the earnings from the dial-up business vanish. Armstrong acquired Arianna Huffington’s Huffington Post in March for $300 million. “They hope that the display advertising and ad network businesses will basically compensate for” the losses in the dial-up unit, says Sameet Sinha, an analyst at investment bank and research firm B. Riley in San Francisco. “The Huffington Post is essentially the cornerstone of their branded display strategy.”

Using discounted cash flow and sum-of-the-parts analyses, Sinha estimates that AOL might fetch $22 to $28 a share as a takeover target. He says the dial-up business would be particularly appealing to a private equity firm, even though it is in decline, because it has high margins and doesn’t require any additional investment. AOL’s access service had 3.4 million subscribers as of June 30, down 23 percent from a year earlier, according to regulatory filings. The business will generate about $1.5 billion in earnings before interest, taxes, depreciation, and amortization from 2011 to 2013, Sinha estimates. So a private equity firm could offer $1.5 billion for the access business knowing that there would be enough cash flow to pay off the cost of an acquisition within three years. “Everything after that is pure profit,” he says.

“The entirety of AOL is more compelling for private equity today, whether to take it over or buy it and split it up,” says Clayton Moran, an analyst with Benchmark, a research and investment banking firm in Boca Raton. That’s because private equity firms can create a financial model based on the dial-up unit’s “manageable declining cash-flow story,” he says.

The risk for someone buying the entire company is that the dial-up business collapses faster than expected and the display ad sales don’t make a significant contribution. AOL’s share of U.S. display ad sales is projected to decline to 4.2 percent this year, down from 6.4 percent in 2009, according to New York-based research firm EMarketer. Facebook will command almost 18 percent of the market in 2011, with Yahoo! expected to draw 13 percent and Google 9.3 percent, according to EMarketer.

“Private equity could look at the business,” says Ken Sena, an analyst at Evercore Partners, and “decide that the company is worth a lot more than its current price tag … The question is, between now and when the access business ultimately declines, will they be profitable enough?”


    The bottom line: Even as customers abandon AOL’s service, the business could deliver $1.5 billion in cash flow over the next three years.

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