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Suddenly relevant

October 2005

Suddenly relevant

Commentary: Google, AOL, Comcast gets my vote

By Bambi Francisco, MarketWatch
October 17, 2005

SAN FRANCISCO (MarketWatch) - Who will emerge as the next suitor for AOL?

Yahoo! Inc. (YHOO) is reportedly having "informal" talks with Time Warner's (TWX): AOL unit to buy AOL's Web portal, according to reports Friday and over the weekend. A report earlier last week said that Google (GOOG): and Comcast are (CMCSK) interested in jointly buying a minority stake in AOL. This follows a NY Post report in September that Microsoft was in talks with AOL, which at the time was not the belly of the ball it is today.
It's enough to make you wonder whether News Corp (NWS) and Viacom (VIA) won't come in as well.

After all, from a competitive standpoint, it would behoove all competitors to stay informed and get access to what AOL is sharing with any interested party. Whether the suitors have a real strategic plan to own AOL, or whether they just want to stay privy for competitive reasons, is the question.

Well, one question. The others are: Why is Time Warner interested in selling AOL when it's spent resources to build it up, and especially when the Internet advertising business is booming? Why is AOL so valuable? Who does AOL make sense with? What is it worth? And, will the structure of the deal turn out to be a remake of that convoluted media mess - NBCi?

Here are some answers.

Why Time Warner is interested in floating the AOL balloon:

Valuation recognition.

We all know the bankers' tactics of how to get valued -- get a suitor to put in an offer, float it to the public, and get others involved in a bidding war. "Time Warner wants a stake in the ground on AOL's valuation, given the debate swirling around Time Warner's sum of the parts valuation," wrote Michael Nathanson, an analyst at Sanford Bernstein.

Why AOL is valuable:

AOL's advertising revenue is growing faster than the overall online ad market and accounts for 10% of total ads placed on the Web, through the first six months of this year. AOL's ad sales soared 45% to $631 million in the first six months of the year, according to Ken Marlin, of investment boutique Marlin & Associates.

By comparison, marketers spent $5.8 billion in online ads for the same six-month period, according to the Interactive Advertising Bureau. That means AOL's ads are more than 10% of the total online ad market. Assuming AOL continues to grow faster than the overall market, it could generate $1.2 billion in ad sales for the entire year.

That is a ton of cash that Microsoft and Yahoo! Inc., which provides sponsored advertisements to AOL, would not want to lose its share of that pie either. AOL generated about 12%, or $382 million, of Google's $3.2 billion total revenue in 2004, according to Google's filings. AOL accounted for 11% of Google's revenue for the first six months of this year. According to Citigroup analyst Mark Mahaney, AOL accounted for 2.6% of Google's net revenue in the June quarter. There is a risk to Google, therefore, of losing that revenue if AOL were to end up in the hands of a rival.

AOL still has 20.8 million Internet subscribers, as of June. But it's been losing about 2 million a year since 2002. Where are those subscribers defecting to? AOL's shrinking dial-up subscriber base is attractive as they transition to broadband not only for Internet access, but eventually for movies. It's unclear whether Time Warner's broadband division ever knew how to win those subscribers over. Comcast and SBC Communications seem to have been the most aggressive at getting broadband subscribers. Comcast is expected to have 8.2 million broadband subscribers this quarter, according to Bernstein's Nathanson.

If communications portals are coming -- meaning a platform where users spend time chatting via voice, IM or email -- then AOL's 49 million IM subscribers are a very attractive pool. It's twice the size of MSN's, with 24 million, and Yahoo, with 22 million. Google has just 1 million, according to Citigroup. Now that Skype Technologies, with 54 million registered subscribers to its voIP/IM service, is in the hands of eBay, AOL's IM client looks even more valuable. By the way, the time spent chatting via IM, voice and email shot up 44%, in August, according to Morgan Stanley and comScore figures. Finally, AOL was the third fastest-growing search site in August, with traffic up 8% to 37 million unique visitors.

Why Google, Comcast and AOL makes sense:

Google and AOL are a good match. They're sort of a left-brain and right-brain complement. Google's a hard partner to pass up because its constant engineering focus helps it to continually improve the relevancy of listings. It's hard to quantify for me, but qualitatively, Google's Web searches are far more comprehensive and relevant. (Note: On the desktop search, I like Yahoo and X-1 Technologies.) I guess that's why traffic to Google sites shot up 38% in August, that's nearly 4 times faster than the second fastest growing search property, which was Yahoo's. And, that's far faster than MSN search traffic, which grew 7%, according to comScore Networks

So, why should Google care about AOL? Besides the fact that AOL is a highly significant distribution partner -- accounting for 2.6% of Google's net revenue -- AOL's Time Warner has a significant amount of Internet real estate to give Google a boost in branded advertising. To date, Google has yet to show that it can tap into the CPM-based advertising market. The Time Warner Network of sites was the No. 1 property across the Internet in June with 118 million unique visitors. Google was No. 4, by comparison. As Google's automated advertisements in content pages grows or as Google gets into image or video advertisements, the experience and content AOL and Time Warner would bring might be valuable. To be sure, it's unclear how much of Time Warner's other properties and content would be available to Google.

Finally, this may be the easiest and the most obvious reason AOL and Google make sense: a combined AIM and Google Talk. Google is just starting in this area, which means it may need AOL. But while AOL is in a position of strength as the dominant leader, it's also the one that can lose the most, especially now that everyone's awoken to the importance of IM and voIP, thanks to Niklas Zennstrom's Skype. Sure, AOL can open up its IM universe to Microsoft, Yahoo or both. But these three IM services are largely the same. Only Google's and Skype's are really simple and clean. A combined AIM and Google Talk might be a far superior product. Google focuses on simplicity, quality and utility. AIM is about content. Combined -- a person can get one or the other -- a Google Talk clean product, or an AIM product with all the bells and whistles. Google could also secure ad listings on the AIM product, to the extent AIM becomes more of the gateway to and searching platform on the Internet. Google might even give AOL a bigger slice of that revenue.

As for Comcast's role, it might be able to help Google roll out free or very low-cost WiFi across the country. Google can be the home page and the search engine. Comcast may also be able to drive AOL's defecting subscribers to a combined Comcast/AOL broadband service. AOL's Time Warner relationship would also be able to provide the exclusive movies.

To be sure, a closer tie among the three might not guarantee that Time Warner's content will be exclusive to Comcast and Google. And, it's unclear why, owning AOL, would give Comcast a better shot at winning over dial-up defectors. Yahoo and its Internet access partners SBC Communications and Verizon (VZ ) may just as easily come in and lure customers with dirt-cheap prices.

Is AOL worth this much?

Assuming AOL does generate $1.2 billion in revenue this year, and assuming a 50% cash-flow margin, AOL could generate $631 million in cash flow this year, according to Citigroup's Mahaney. If one applies the low-20-multiples that are being assigned to Google, Yahoo and eBay, AOL's advertising business could be worth about $12 billion.

To be sure, to the extent that an AOL play is partly about getting content from Time Warner, I'd rethink that. There may be no guarantees that buying into AOL means 100% access to all of Time Warner's content. 

Copyright © 2005 MarketWatch, Inc. All rights reserved.

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