How Time Warner Clicks With Google.

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From Standard & Poor's MarketScope

Its deal with the Net giant boosts AOL's ability to sell search ads, says S&P. And it meshes well with the unit's turnaround strategy

In one of the most anticipated media announcements of the year, Time Warner's (TWX; S&P investment rank 4 STARS, buy) AOL unit and Google (GOOG; 3 STARS, hold) unveiled an expanded partnership on Dec. 21, including an enhanced global advertising partnership and a $1 billion investment by Google for a 5% stake in AOL [see BW Online, 12/21/05, "AOL-Google: Who Gets What?"].

As part of the collaboration, Google plans to work with AOL on video search and offer AOL's premium-video service within Google Video. This will allow users of Google Video to search for AOL's premium-video services. Display advertising throughout the Google network will also increase.

CONTENT POTENTIAL. AOL will gain the ability to sell search advertising directly to advertisers on AOL-owned properties, instead of directing advertisers to Google. The alliance also involves interconnectivity between AOL Instant Messenger and Google Talk.

"We think the deal should be mostly positive for Time Warner, as it would offer AOL increased flexibility over the long term to grow its advertising revenue base, and monetize its branded content through broader exposure for AOL's vast stable of online properties, consistent with what we view as its well-articulated turnaround strategy," says Standard & Poor's Media & Entertainment equity analyst Tuna Amobi.

Amobi also likes the deal because it doesn't unbundle AOL's declining access unit, which could have complicated future IPO or spinoff plans. Still, Amobi points out that it's not clear if AOL extracted a minimum revenue guarantee, and the $20 billion value implied by Google's investment is below peer levels based on enterprise value/EBITDA and price/free cash flow.

UNHAPPY CAMPER. Time Warner has long wanted to use AOL to capture a larger piece of the quickly expanding online-advertising revenue pie, which is estimated by Standard & Poor's Equity Research as growing multiple times faster than the overall advertising market. Furthermore, Google also hopes to sell more ads with the help of AOL's 300-person advertising-sales force. Future developments could include digitizing Time Warner's expansive media content, which would likely help Google extend its search capabilities to books, movies, and television programs.

However, one Time Warner shareholder is not in favor of the deal: activist investor Carl Icahn, who has been waging a proxy campaign to break up Time Warner [see BW Online, 12/19/05, "Time Warner: Still Searching for Answers"]. Icahn believes the Google announcement could be negative for the company because it could forestall future deals involving AOL.

As for Google, S&P Internet Software & Services equity analyst Scott Kessler sees the deal as positive for the search outfit, "enabling it to retain its largest customer, provide more branded options to advertisers, and expand in two emerging categories, to the detriment of its most significant competitors, Microsoft (MSFT; 5 STARS, strong buy) and Yahoo! (YHOO; 3 STARS)."

RISKS WITH MICROSOFT. Microsoft is being viewed as a spurned suitor, unable to work out a deal with AOL and thus gain share in the online-advertising market. However, absent potential revenue guarantees, a deal with Microsoft would probably have been more risky for AOL, because Google's online-advertising business is better established than that of Microsoft. The Redmond [Wash.]-based computing giant introduced its own search technology in February, 2005 and is in the process of testing a keyword-based text-advertising offering in three countries.

Moreover, AOL is Google's biggest customer, providing roughly $420 million -- or 10% of its gross revenues in the first nine months of 2005.

Kessler is keeping his hold recommendation on Google shares, reflecting S&P's view of significant risks in the company's lack of revenue diversification and mounting competition in the Internet-search segment. This is coupled with what S&P deems to be an appropriate valuation.