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AOL Spinoff Faces Not Challenges, Not Hurdles, But Steep Cliffs

Today's the day -- AOL (AOL) gets spun off and out of the hair (and off the balance sheets) of Time Warner (TWX), which hopes to look better in the stock race by not having to run carrying dead weight on its back. And how is it going to do? The picture, as it is emerging, isn't pretty.

Morningstar sent over some commentary from analyst Larry Witt. Although we don't get into the breathless what-will-it-trade-at game here, here are his main points about the business:

  • In 2002, AOL had 35 million subscribers and $9 billion in revenue. As of this September, the number was down to 5.4 million, and the trend is likely to continue.
  • In 2006, AOL decided to make content open to anyone and live on the ad revenue. Initially users and ad money increased, but the audience has started to decrease, so Witt guesses that both have peaked and are in decline and unlikely to expand.
  • Smaller audience means fewer search queries and, thus, less money. Plus, AOL negotiated a deal with Google (GOOG), which powers its search, back in 2006 that gave the AOL 65 percent of the search ad revenue. When the deal ends at the close of next year, Google may negotiate harder because it now has 65 percent market share in search, as opposed to the 45 percent of just five years ago.
  • Witt also expects all the core segments of AOL to continue to decline and says that the "tarnished brand" will keep the company from reinventing itself.
I think that the summation is fair -- and damning. Given the Google pact aspect alone, it would seem reasonable to say that the decline will likely shift into high gear come January 2011, unless it manages to get, say, Microsoft (MSFT) to bid under whatever Google demands. And, frankly, that could well happen.

Right now, the AOL search box has "enhanced by Google" under it, but people don't go here to search to get Google when they could just go to Google. So the search engine cache provided is a lot less than you might initially assume. Then again, Google is clearly concerned about Bing (and the more they say they're not, the more you know they are). So Microsoft might become AOL's secret weapon in any negotiation, either as an alternative strategy or as a way to get Google to take less.

But that's just a stopgap measure. Right now AOL is pursuing the "let search numbers tell us what content to create" strategy used effectively by Demand Media. But for all the traffic the latter brings into its network of sites, it supposedly has annual revenue of only about $200 million. I'm not sneezing at that figure, but it does put a company squarely on the very low end of mid-caps. And even if AOL at first "should" be worth $29 a share, as Witt thinks, you have to ask for how long, especially when Morningstar estimates that the big driver of AOL's revenue is still dial-up access and that operating margin might drop from the 26 percent in 2008 (excluding one-time charges) to 10 percent in 2013. Maybe "You've got mail" should become "You've got problems."

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