In one of my last articles on Yahoo! (YHOO, Financial), I mentioned the ongoing campaign for the merger of Yahoo! and AOL (AOL, Financial) as has been proposed by a few of the top shareholders in Yahoo!. There are certain reasons including the unsatisfactory performance of CEO Marissa Mayer, and Yahoo!’s negligible performance behind this proposal. This push was initiated by hedge fund Starboard Value LP via an activist campaign, and recently, the media reported that the hedge fund has taken up a 2.4% stake in AOL. In light of these events and others, let us analyze the prospects of AOL as a worthy investment option.
Last quarter highlights
On November 6, the company announced its third-quarter earnings; it posted 18% year-over-year growth in global advertising revenues to $626.8 million, while the net income grew by 1325% year-over-year to $28 million (flat sequentially). This was AOL’s seventh consecutive quarter of revenue and OIBDA growth and in Q3, total revenue grew a reasonable 12 percent. AOL aquired Adap.tv in September 2013, a programmatic video advertising platform. A good number of analysts were expecting Adap.tv to be a big revenue driver for the company, and as it turned out, the programmatic revenue surged a whopping 37 percent in the quarter. AOL’s strength in programmatic buying space will bolster its standing in the third party ads segment.
Programmatic buying is where the growth is
According to an AOL survey that appeared in August 2014, 76% of advertisers buy display via programmatic, while 56% buy mobile inventory via programmatic; 48% use programmatic for video ads; 24% for social; 32% for search; and 13% for television. From the agency perspective, 86% are buying display via programmatic, 60% for mobile and video, 34% for social, 24% for search, 7% for television. Therefore, it is clear that programmatic ad platform is going to be the high growth area in coming years in the digital advertising market. As such, AOL’s acquisition of Adap.Tv and aggressive push for utilizing its competency in this area, is the right thing to do. The company is already developing its programmatic ads platform to sell more ads on third party sites and that too, across different platforms and formats.
The programmatic platform also has its drawbacks. One of the biggest challenges cited by brands and agencies is “inventory quality” as in case of programmatic buying, it is quite difficult to gauge the quality of websites the ads are being placed on. As a result, brands are concerned that faulty targeting or bad quality of the website can distort their advertising message and prove unhealthy for their image.
The merger implications
Coming back to the point I began this article with, Starboard Value has taken a 2.4 percent stake in AOL. It is important to note that Starboard also picked up a 0.8 percent stake in Yahoo! in the same period. It is obvious that this event assumes high significance considering the potential of both companies and the fact that both of them have just begun their growth journey. Starboard had petitioned Yahoo! for a merger with AOL in order to strengthen its competitive position, but was not successful in securing the merger. At that point in time, neither Yahoo! nor AOL seemed convinced about the merger. However, now that Starboard has picked up a stake in AOL, there may be a shift in this position in the coming months. Considering that, it would be prudent to understand more about the overall effects that could be brought about by this merger.
Starboard is proposing a merger where the email and advertising business of Yahoo! will be absorbed by AOL, resulting in approximately $1.5 billion in cost-savings for the combined entity. If the merger occurred as Starboard envisions it, a mechanism called a reverse Morris trust would likely be used. In this scenario, Yahoo!’s web business would be absorbed by AOL, and Yahoo! shareholders would be compensated by receiving a majority stake in the combined company. In addition, Yahoo!’s stakes in Alibaba (BABA) and Yahoo Japan Corp would remain on Yahoo!'s books.
While the combined entity would save $1.5 billion (as calculated by Starboard), any direct benefit to AOL is unclear. As I mentioned in the above paragraphs, the company has grown phenomenally in the past quarters and CEO Tim Armstrong has consolidated the position of AOL in digital advertising by focusing on driving display and video ads. However, there is a limit to which AOL can rise independently because of availability of limited resources and even if grows revenue at current rate, it will be long before it inches anywhere close to stalwarts like Facebook (FB) and Google (GOOG) (GOOGL).
In such a situation, Yahoo! could be a potential partner that brings capital resources on board (remember the huge stake in Alibaba and Yahoo Japan) and helps AOL in expanding on its advertising portfolio. Thus, the combined entity could have a better shot at inching to the third spot in digital advertising space, not far from Facebook.
Takeaway
So far, both Yahoo! and AOL have downplayed the possibility of any merger, but with Starboard picking up stakes in both, these companies could carry on its activist campaign. If the hedge fund becomes successful in achieving its objective, then the shares of AOL will definitely see some shakeup.
