Deja Vu: AOL Nears New Growth Inflection Point

Brief:
1) AOL spun out of Time Warner four years ago and closed at $23.50 on the first day of trading.
o Since then, the company has executed superbly, making two major acquisitions, the Huffington Post, and Adap.tv, and repurchasing 25% of its shares.
o Shares peaked above $50 recently and have pulled back to the low 40s on vague and lackluster 2014 EBITDA guidance.

2) I believe the company will emerge in the next six months as a growth asset with a stable legacy business with significant margin and multiple expansion potential.
o Near term target price is $75 with potential to potentially exceed that on a 12 month horizon, with additional optionality on asset sales and NOL benefits.
o CEO Tim Armstrong is a 5%+ holder, aligning his incentives for increased profitability and share appreciation.

Thesis:
1) AOL operates in three segments, each of which contribute about a third of revenue. Each of these segments is at a key inflection point.
o Brand group: Key assets include Huffington Post and tech blogs TechCrunch and Engadget.
• Huffington Post has become the number two global news provider, surpassing CNN. Established assets are now poised to see meaningful margin expansion, and should run rate at 20+% versus 5% in 2013.
o Membership group: Has launched a new product called Gathr, which consolidates online subscriptions services and sells them as a package to membership subscribers.
• Segment has hit record low churn rates of 1.3%, down from almost 3%, 3 years ago. The segment has the potential to stabilize revenue through new product investment.
o AOL Networks: Is seeing unprecedented growth, as a leader in programmatic online advertising and video.
• Company served 4.3bn video ads in December, number one in video advertising for the entire quarter.
• Signed marquee clients like ESPN and Conde Nast in last quarter. Segment has potential to see meaningful growth as the video and programmatic ad leader.
• Incremental margins in advertising networks are high double digits, and the segment is currently only on the cusp of profitability.

2) After growing EBITDA 70mm in 2013, the street expects only of half of that in 2014 (35mm) starting from a baseline which was the company's stronger quarter in history.
o The company has rationalized 45mm in unprofitable revenue through the sale of its patch asset, which will be accretive to EBITDA in 2014.
o Incremental margins on both the brand and network businesses are very high, and the company has set the bar very low for the 1H of the year providing upside optionality.
o I believe the company can grow EBITDA by at least the same amount in 2013, or approximately 550mm for 2014 in total, which seems more reasonable than current expectations.

Valuation:
1) The predominant valuation methodology for AOL is an EBITDA driven Sum-of-the-Parts which understates the value of the inflecting growth assets.
o Applying a 12x EBITDA multiple to a mid-teens margin brand business (should be 20%+ run rate), a conservative 2.0x sales multiple to the fast growing networks business, and a 5x EBITDA multiple to what could potentially become a stable subscription business, the company should be worth $75 a share.
o If the company fails to execute near term, I believe a trough 6.0x EBITDA multiple for the wholeco on 500mm in EBITDA, or $37.50 a share, is appropriately conservative.

2) There is ongoing speculation of the company potentially being acquired. I believe the company's successful return to being a growth asset with emerging profitability strengthens that position and makes a potential acquisition more likely in 2014.

3) This valuation analysis ignores substantial net operating losses on AOLs books, which are offset by valuation allowances, but are possibly still sale-able. In the case that AOL is able to monetize these in the near term, there is meaningful upside to my current thesis, as the market will ascribe value to these non-cash assets.