AOL's Last Gasps at Profitability

AOL is, if anything, a survivor. As Kara Swisher detailed, since its founding, AOL lurched from one crisis to another. Each time, it found a way to live another day. In 2000, AOL bought media conglomerate Time Warner in an all stock deal. The purchase turned out to be, arguably, the worst merger in American corporate history. Less than 10 years later, Time Warner jettisoned AOL after achieving inferior financial performance. In 2012, the newly independent AOL's stock price has hit post-spin off highs, improving almost 100 percent.

However, the company's financial performance appears worrisome because it has been achieved by artifice and not good management. Indeed, its strategy does not lend itself for continued superior financial performance.

AOL owes its stock rise to two sources. One, it sold a lot of its intellectual property. Two, it continues to generate a significant amount of margin from its dial service.

In 2012, Microsoft purchased 800 patents from AOL for $1.056 billion. Instead of investing its windfall into projects that could provide a sustainable competitive advantage, AOL is buying back its stock. These two, interconnected decisions appear problematic for several reasons.

Patents represent a non-renewable resource. When a company sells its patents, it cannot simply replace those patents with another set of patents. Furthermore, a stock repurchase typically fail to lift a company's value because would-be owners know management lacks better ideas for use of that cash than to simply return it to the owners.

That is, AOL's management cannot find a marketing program to fund, a competitor to purchase (or sort of repurchase Time Inc.), a new product to create, a new market to enter that would mark a better use of its financial resource than to buy back its stock. No one would want to own stock in a company with that type of management.

The dial-up service continues to throw off cash. The subscription base has fallen from around 26 million access subscribers in 2003 to 2.8 million in 2012, an 89% decline. However, in 2012, the dial-up service accounted for about 25% of AOL's revenue. Dan Frommer writes the money conclusion:

 “Membership Group” — including AIM, AOL Mail, search revenue from AOL subscribers, etc. — generates the biggest chunk of sales and more than all of its profits.

Meanwhile, AOL’s “Brand Group” — AOL.com, HuffPost, Patch, Engadget, TechCrunch, etc.; the future of the company — generates almost as much revenue but almost zero profit.

AOL would not be the first company to hang on to a cash cow. However, owners should not trust AOL's management with this cash cow. Given how the company spent its windfall from Microsoft, owners should expect more stock repurchase activity. With that view, AOL, which survived from so many near-death experiences, may not survive the reign of Tim Armstrong.