Vanishing Subscribers Hurt AOL’s Search Business

AOL (NYSE:AOL) is losing share in the Internet search market, where it competes with Google (NASDAQ:GOOG), Microsoft (NASDAQ:MSFT) and Yahoo (NASDAQ:YHOO). In the company’s earnings report for the second quarter of 2010, management noted that AOL’s search problems are being caused primarily by the steady decline of its legacy dial-up subscription business.

We  expect these negative trends to exert downward pressure on AOL’s share value going forward. Accordingly, we have reduced the Trefis stock price estimate for AOL from $27.79 to $24.97. Our analysis follows below.

AOL by the numbers

Once known primarily as a dial-up Internet access service, AOL now makes most of its money by selling advertising against free content on its own network of sites as well as third-party sites. Display ad sales currently constitute 52.7% of the Trefis stock price estimate for AOL, versus 13.8% for the subscription business.

Search advertising, which is a much more profitable business than display advertising, contributes another 12.2% to AOL’s share value according to our estimate.

Search woes

AOL’s search market share slipped from around 6.2% in 2006 to 3.2% in 2009. AOL captured only 2.3% of the search market in July 2010 according to Comscore, an Internet market research company. We expect this decline to continue over the next few years, reaching 1.8% by the end of the Trefis forecast period.

We have priced this anticipated decline into our current price estimate for AOL’s stock. However, the stock could see an additional downside of 4% if AOL’s search market share slides to 1% by 2016.

You can drag the trend-line in the chart below to create your own search market share forecast for AOL and see how it impacts the company’s estimated share value.

Vanishing subscribers

AOL’s search advertising revenues declined from $120 million in the first quarter of 2010 to $106 million in the second quarter. According to management, this decline was driven primarily by the steady disappearance of subscribers who use AOL search as their home page.

AOL’s  total subscriber count has dropped steadily in recent years, from around 25 million in 2005 to around 5 million in 2009. Meanwhile, U.S. broadband penetration increased from 28% in 2004 to 69% in 2009.

AOL currently sells dial-up and broadband Internet access. AOL does not provide the actual broadband connection, but works with third-party service providers. We believe that cable and telecom companies will continue to gain market share at AOL’s expense because they offer higher broadband speeds.

We expect AOL’s subscription business to vanish almost entirely by the end of the Trefis forecast period. You can drag the trend-line in the chart below to create your own subscriber count forecast for AOL and see how it impacts the company’s stock price.

And you can see the complete $25 Trefis Price estimate for AOL’s stock here.