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AOL Earnings: Is Patch a Bomb -- or a Secret Weapon?

It was a bad news/good news earnings announcement for AOL. The bad: a net loss of $11.8 million only looked good in a year-over-year comparison because the 2010 results included a massive goodwill write-down. Otherwise the comparison would have been to $359 million net income. The good news? Ad revenue grew by 5 percent.

Cold comfort for a company racing to build its revenue as its traditional mainstay of dial-up subscription accounts drops by 23 percent year-over-year. AOL needs new growth opportunities, badly -- and that's what Patch, the hyperlocal content arm, is supposed to help provide.

So far, the effort has received little but scorn from the media commentariat, who dismiss the large investment AOL has poured into Patch. Is management really clueless? Or do facile sidelines analyses miss something important? Some reflection on conversations with the people at the top of Patch leave me wondering.

You spent how much?
For a company challenged by a dying foundational pillar, the money that AOL has poured into Patch looks alarming. Barclays analyst Douglas Anmuth estimated earlier this year that the company would spend $120 million in 2011 alone on the hyperlocal sites. According to AOL, one big reason for its net loss last quarter was increased investment in Patch.

Some in the media, particularly Nicholas Carlson at Business Insider, who seems to have declared himself the nemesis of Patch, think that while success isn't completely impossible, it's pretty close. HuffPo gets many more readers with a fraction of the 800-plus editors that Patch needs to drive its ever-expanding network of sites, so how can Patch catch up and become profitable?

At the same time, AOL says that Patch -- not Huffington Post alone, as some reports have suggested -- is also one of the drivers of the company's overall 18 percent growth in domestic display revenue. So, is Patch the doom of AOL or its savior?

What does Patch say?
To even look at such a murky question, you need more data. When I spoke to Patch President Warren Webster in June, he insisted that the division was hitting or exceeding all of the target numbers its plan called for (caveat: I can't independently verify much of this):

  • Traffic in May was 9.2 million unique users. (I'm waiting for June and July figures.) But in general, unique visitors have grown at about a 3 million a month pace. If that rate continues -- and that's a big if -- Patch would surpass HuffPo's traffic within a year.
  • Market penetration on sites that opened early in 2009 "pretty quickly" hit 50 percent and eventually rose to between 80 percent and 90 percent, according to Webster. For newer sites, "the vast majority of them are following the same trajectory in traffic growth," he says.
  • Webster says that Patch sites can operate at 4.1 percent of the cost of a local daily newspaper in a small community.
  • The company's sweet spot for new Patch locations is between 15,000 and 50,000 residents showing various signs of high community cohesion and involvement.
  • According to Editor-in-Chief Brian Farnham, the plan is to be in 1,000 communities by the end of this year. "Our model is built on a single full-time professional journalist plus some additional resources to cover it," he says. Sites use some freelance help and there are salespeople who cover groups of Patch sites.
Critics have assumed that the $120 million figure (if even accurate) is the ongoing cost to run Patch. But is that reasonable, or does it hold a lot of one-time start-up costs for the individual sites?

Working from the bottom up
It's time for a bottom-up estimate instead of the top-down guessing that's largely been making the rounds. Here are the assumptions:

  • 1,000 Patch sites, one editor per site, each making about $40,000 in salary
  • average of three freelancers contributing twice weekly at $50 per contribution
  • 1 salesperson for every 4 Patch sites
  • one big unknown is overhead and infrastructure costs
Starting with where we can guess, Multiple the editors times the number of sites and you get $40 million. Add 30 percent additional for benefits and overhead and it hits $52 million. Three freelancers with two $50 stories per week per site is $15.6 million. One salesperson for every 4 patch sites means 250 salespeople. Give them $60,000 a year plus 30 percent for benefits to arrive at $19.5 million.

Add those numbers and you're at $87.1 million. Patch still has more overhead and infrastructure costs. So bump the costs up to $100 million a year.

Divide that number by 1,000 sites and each Patch site needs to gross $100,000 a year, or $8,300 a month. I don't think that the critics who write off the possibility of Patch actually being successful work through the numbers to this level. Sorry, but $8,300 a month isn't that big a nut to crack. Get those sites up to $120,000 a year, and suddenly you have a business with 20 percent operating income.

I can understand being skeptical. I've had some pretty pointed things to say about AOL and its management. But, looking at the numbers, this isn't an impossible position. Patch's future is hardly assured or easy.

And yet, combine local ads with the daily deal partnership with American Express and AOL's ability to sell national ads, and making that level of marketing income for communities that run into the tens of thousands in size doesn't seem like that much of a stretch.

For whatever reason, though, many in the industry seem inclined to look for how Patch could fail, and not whether the actual dynamics and some reasoning suggest that it might.


Money image: morgueFile user Alvimann, site standard license.
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