AOL (NYSE:AOL) generates its ad revenues through display ads (e.g. banner ads, skyscraper ads) on AOL sites like AOL News, AOL Money & Finance, as well as display ads on external sites that partner with AOL. It competes with Yahoo (NASDAQ:YHOO), Google (NASDAQ:GOOG) and Microsoft (NASDAQ:MSFT) in this market. AOL’s search business (AOL.com) also generates ad revenue through keyword advertising that is powered by Google. It competes mainly with Microsoft and Yahoo; however, Facebook has also started to become another potent threat to AOL in this market.
We estimate that display advertising (including third party sites) and search advertising business accounts for around 32% and 13% of our $23.94 Trefis price estimate for AOL stock. Our price estimate stands roughly 18% above market price.
Here we explore the downward scenario for AOL’s display advertising business, which would justify some of the difference between our price estimate and the current market price.
AOL continues its rebuilding efforts..
In spite of the general revival in the U.S. online advertising industry, which grew from $5.5 billion in Q3 2009 to $6.4 billion in Q3 2010,  AOL’s revenues from U.S. display advertising business declined from $152 million in Q4 2009 to $140 million in Q4 2010.  This had an effect on AOL’s RPM, which declined from $4.35 per 1,000 impressions in 2007 to $2.80 per 1,000 impressions in 2010.
However, AOL has started to take a few initiatives in order to create more ad monetization opportunities for itself. For example, last year AOL extended its search partnership with Google in which one of the terms of the deal was to make AOL videos available on YouTube. YouTube’s reach is massive and AOL should benefit here as videos carry higher RPM rates than online text content. We discussed about this benefit in our earlier note titled Google Search Deal Could Yield Small Upside for AOL’s Stock.
AOL has taken a few more initiatives by making a few strategic acquisitions over the course of last year. It acquired Pictela and launched “Project Devil” to reduce visual clutter on web pages. This project was launched with an aim to enhance ad space functionality in order to draw higher user engagements levels (See Success of Project Devil Could Create 13% Upside to AOL Stock). AOL also acquired StudioNow, a video syndication website, in order to place more video content on its properties (See StudioNow Acquisition Can Boost AOL’s Ad Revenue).
These are some of the factors which we believe could bring about a revival in AOL’s display advertising business. We estimate that AOL’s RPM levels could improve from here on, and reach around $3.20 per 1,000 impressions by the end of Trefis forecast period.
..But the risk remains
Although the rebuilding process started by AOL looks promising, the implementation would be the key for the company. If AOL fails to make the correct strategic decisions going forward, it could provide risk to our estimates. To gauge the downside effect on AOL stock, if AOL’s RPM levels continue its historic rate of decline, and reach around $2 per 1,000 impressions by the end of Trefis forecast period, there could be a downside of 7% to our estimate for AOL stock.Notes: