Making the Value Case for Armstrong's AOL

NEW YORK (TheStreet) -- After quadrupling in price from $10 in August 2011 to more than $40 in May, investors seem to have gone asleep on AOL (AOL), again.

It required a mention by Jim Cramer on an Oct. 18 edition of "Mad Monday" to remind investors that AOL is still very much alive and kicking -- and was at that time trading in the low $30s. The stock jumped 3.1% the following Monday.

There was also an interesting blog post from Nyonnais around the same time on why he had taken a large long position in AOL recently.

Cramer argued that the stock is too cheap and the assets are too good to be ignored. Buying the shares gives you the growth potential of Huffington Post and TechCrunch as well as AOL's many various video properties, which actually serve up more video ads than YouTube. Those are the most exciting aspects of the portfolio even though most observers only pay attention to Patch and the dial-up business.

You get all these for a market cap of $2.8 billion. This for a company that generated net income of $500 million in the past year. This means you're getting the business for an Enterprise Value to EBITDA ratio of less than 5 times. In the meantime, the industry average is closer to 11 times and so-called sexy stocks such as LinkedIn  (LNKD)are closer to 35 times.

Even if you sold off the various acquisitions that AOL has made over Tim Armstrong's tenure, you get to a much higher number than the company's current market cap.

Nyonnais, a value/event-driven investor blogger from Switzerland, is making his bet not so much based on price but on AOL's strategic value to a buyer like Yahoo! (YHOO).

He argues that the dial-up business, which is still generating $500 million a year in cash flows, should be worth $1 billion in a wind down scenario. So you're really getting the Internet properties for $1.5 billion and that's attractive for Yahoo!.

Nyonnais argues that the brands part of AOL can bring in $800 million in revenue next year, while its third-party network can generate $700 million next year. That's $1.5 billion in revenue from a company that's being valued at $1.5 billion today (less the dial-up business).

Although I rarely like buying a stock because of the chance that someone else may buy it in the future, I agree with Nyonnais' reasoning for the most part here that AOL would be a good fit for Yahoo!.

It would bring premium brands and premium video under the Yahoo! tent. Whatever its traffic is today, Yahoo! can likely increase it through referrals. Yahoo! also needs all the premium content it can get these days.

It would be fun to see Tim Armstrong working alongside Marissa Mayer at Yahoo! as well.

Probably the biggest reason why Mayer would be tempted to do this deal now, though, is that she needs to show that she's moving the needle of the core business revenue. Layering on an extra $1.5 billion to a business that chugging along trying to show growth to its $5 billion run rate would be big enough hocus pocus to make it appear that the "core business" is growing, even if it isn't actually.

Nyonnais believes that a possible cash-rich split scenario involving Yahoo!'s stake in either Alibaba or Yahoo! Japan could give Yahoo! an incentive to pull the trigger on buying AOL.

It's not a sure thing that Yahoo! will do a cash-rich split. However, if it does, the logic is sound. Were it to sell its stake in Yahoo! Japan today, for example, it would be worth $10 billion. Most analysts model that Yahoo! would then have to pay about $3 billion in taxes on that sale.

In a cash-rich split scenario, Yahoo! Japan buys its stake back from Yahoo! for $10 billion, but gives Yahoo! $6.67 billion in cash and $3.33 billion in "other assets."

That other asset could be AOL, which Yahoo! Japan would buy and then hand over to Yahoo! along with the cash in exchange for its stake back. In this scenario, neither Yahoo! nor Yahoo! Japan pays taxes on these stakes as they are considered by the IRS to be swapping assets.

Yahoo!'s essentially getting AOL for free instead of paying the IRS $3 billion in cash, plus the $7 billion in cash for their Yahoo! Japan stake. And the core business gets to show "growth" from the layering on of AOL. Everybody is happy -- although AOL would probably want a much higher price than $3 billion.

There's a lot of sound logic to Nyonnais' idea. Even if it doesn't happen, though, AOL at these levels is cheap relative to a lot of other Internet names.

At the time of publication, Eric Jackson was long AOL and YHOO.

This article is commentary by an independent contributor, separate from TheStreet's regular news coverage.

At the time of publication, Eric Jackson was long AOL and YHOO.

Eric Jackson is founder and Managing Member of Ironfire Capital and the general partner and investment manager of Ironfire Capital US Fund LP and Ironfire Capital International Fund, Ltd. In January 2007, Jackson started the world's first Internet-based campaign to increase shareholder value at Yahoo!, leading to a change in CEOs in 2007. He also spoke out in favor of Yahoo!'s accepting Microsoft's buyout offer in 2008. Global Proxy Watch named Jackson as one of its 10 "Stars" who positively influenced international corporate governance and shareowner value in 2007.

Prior to founding Ironfire Capital, Jackson was President and CEO of Jackson Leadership Systems, Inc., a leadership, strategy, and governance consulting firm. He completed his Ph.D. in the Management Department at the Columbia University Graduate School of Business in New York, with a specialization in Strategic Management and Corporate Governance, and holds a B.A. from McGill University.

He was previously Vice President of Strategy and Business Development at VoiceGenie Technologies, a software firm now owned by Alcatel-Lucent. In 2004, Jackson founded the Young Patrons' Circle at the Royal Ontario Museum in Toronto, which is now the second-largest social and philanthropic group of its kind in North America, raising $500,000 annually for the museum. You can follow Jackson on Twitter at www.twitter.com/ericjackson or @ericjackson.

You can contact Eric by emailing him at Dr.eric.jackson@me.com.

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