In October of last year, I wrote a blog entitled “Why I’ve made a large bet on AOL.” My main thesis was that AOL was likely to be acquired at a substantial premium, with the most likely acquirer being Yahoo. I argued that the Alibaba IPO was likely to serve as the catalyst for a deal that has been long talked about, but never seems to materialize.
A little more than six months have passed, and AOL has gained around 29 percent, versus nine percent for Yahoo, and more than five percent in the Nasdaq. Obviously, a deal hasn’t happened yet. But, given events over the past six months at both companies, and with the Alibaba IPO now moving forward, I believe a major tie-up between Yahoo and AOL is still in the cards. Here’s a rundown of the original thesis, with an update of where things stand today:
I argued that with the upcoming Alibaba IPO, Yahoo was reaching a stage where investors would start to care again about weakness in its core business. Since then, Yahoo reported a drop in revenue of two percent year over year in Q4 2013, and growth of one percent in Q1 2014. Tumblr may prove to be an excellent investment in the long run, but it’s not yet moving Yahoo’s revenue needle. The core business of Yahoo has shown some signs of stabilizing, but there’s still no real growth to speak of.
In contrast, AOL’s ad revenue grew 14 percent in 2013. In the fourth quarter, it surged by 23 percent, with 63 percent growth in its “third-party network” revenue — money that AOL generates from sites it doesn’t own, but sells ads on through its networks/platforms business.
Commentary from Yahoo’s side on priorities has largely been positive for the Yahoo/AOL combination thesis. Since I wrote my original article, Yahoo’s CFO, Ken Goldman, has talked on a number of occasions about Yahoo’s interest in “revenue growth accretive” acquisitions that are consistent with Yahoo’s core strategy. While it’s hard to pin down precisely what Yahoo’s core strategy is, last month, in an interview with the Wall Street Journal, Ned Brody, Yahoo’s Head of Americas (and former head of AOL Networks) talked about Yahoo’s ambitions in the ad tech space, specifically Yahoo’s desire to become a network business, generating revenue from non-owned and operated sites. He stated:
“… we are thinking about the business of Yahoo much more as a network business model rather than strictly an owned operator publisher mindset, which drives you to very different decisions and investment paradigms. So I think you will see us continue to invest in that area over the next couple of years. There is a lot of interest there and there is a lot of advertiser money to be spent.”
Brody is essentially saying that Yahoo wants to do what AOL is doing now. And yet, over the past year, aside from hiring Brody from AOL (interestingly, only after AOL agreed to waive Brody’s noncompete clause), Yahoo has not invested substantially in its ad tech business — and certainly not in generating revenue from non-owned & operated sites. Indeed, it is odd (in my view, at least) that while AOL and Yahoo are in exactly the same businesses, with both evidently aiming to be major players in the networks space, they’ve invested in very different areas over the past year. Marissa Mayer has focused heavily in making the Yahoo user experience more modern and beautiful. Aside from Tumblr, her acquisitions have mainly been to boost engineering talent.
Despite saying that it’s a priority, Yahoo does not yet have a credible competing product in the networks space. They do not currently have a way to make substantial revenue from non-owned & operated websites, despite saying they plan to invest in this area.
Meanwhile, with the AdapTV purchase in mid-2013, AOL has gone all-in on programmatic video and its networks/platforms business, while also investing in display and growing revenue through branded (and easily transferable) properties like Huffington Post and TechCrunch. AOL recently bought Gravity — a company that Yahoo also courted — to further boost its networks business.
These investments in very different areas are odd, in my view, unless there is some understanding of a pending business combination. While Yahoo could decide to invest heavily in building up its own ad tech stack to compete with AOL’s, consolidating Yahoo’s networks operations with AOL’s much stronger assets in this space would instantly address Yahoo’s shortcomings in networks, and build scale with less downside risk. A merger would also provide a substantial boost to Yahoo’s stagnant display business, by adding Huffington Post and AOL’s other display assets.
In the original thesis, I also argued that because AOL, Yahoo and Microsoft were working together in cross-selling display-ad inventory, the companies were already tied together, making an eventual deal more likely. What has happened since? It hasn’t been reported in the media, but AOL and Yahoo expanded their display-inventory partnership to the U.K. in the fourth quarter of 2013, as disclosed by AOL in its annual regulatory filing. The takeaway here is that the U.S. display partnership must be bearing fruit for them to expand to U.K. More recently, AOL and Microsoft signed a new distribution deal in which AOL’s video content will be offered up on several of Microsoft’s platforms.
While Marissa Mayer would like to get out of her search deal with Microsoft, the reality is that Yahoo and Microsoft remain strongly tied together, and could benefit from expanded partnerships around display.
Another potential factor that has not been widely discussed is the fact that AOL has significant capital-loss carry-forwards (of around $1.25 billion), which start to expire in 2015. Yahoo could potentially use these to offset some of the capital gains from sales of its Asian assets, with potentially substantial tax savings. While I do not believe this is a major motivating factor behind a deal, it does provide some further motivation for an outright acquisition in the near-term versus a partnership, as it would effectively reduce the cost of a deal for Yahoo.
From my vantage point, AOL and Yahoo remain on a collision course. Even though AOL generates around 35 percent of the ad revenue that Yahoo generates (leaving aside its cash-cow dial-up business), AOL’s market cap is currently only around nine percent of Yahoo’s, thanks to Yahoo’s Asian assets. AOL is really the only affordable purchase that would significantly boost Yahoo’s core business and fill in the gaps in Yahoo’s networks business. Boosting Yahoo’s core will become more and more important as its Alibaba holdings are reduced. In my view, this long-discussed deal makes too much sense now not to happen, and I believe the Alibaba IPO filing starts the clock.
Steven Kapsos is an economist at the International Labour Organization (ILO) in Switzerland. (The author is long both AOL and Yahoo; views expressed by Kapsos on Re/code are not those of the ILO.) He spends his spare time researching the technology sector, and blogs about mergers and acquisitions in the tech space. A graduate of the University of Wisconsin-Madison, with a degree in economics, he earned a master’s degree in Public Administration/International Development from Harvard University. Reach him @nyonnais.
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