Time Warner AOL (TWX): Financial Impact of Cuts

We have updated our AOL forecasts to take into account 20% cost cuts announced this morning.  Most laid off employees will formally exit the company in mid-December, so the cost reductions will hit the income statement in Q108 (we expect the company will take a large charge in Q4 to account for the severance costs).  We believe the cuts should allow AOL to maintain current 2007 EBITDA levels in 2008, even with future subscriber declines.

As described earlier, we believe AOL's EBITDA will drop modestly from Q2 levels in Q3 and Q4, as a result of ongoing subscriber declines and slow growth in advertising revenue.  The subscriber losses will likely continue into 2008, but the cost cuts should make the company's advertising business significantly more profitable than it is currently.  (Detailed quarterly and annual projections here)

New Estimates:

• We estimate that EBITDA for the "Access" business will drop from about $850 million this year to $700 million next year. 
  
• We estimate that EBITDA for the "Media" business will jump from about $300 million in 2007 to $900 million in 2008.

AOL Division Value:

At a 10X-15X EBITDA multiple, the AOL division as a whole would be worth $15-$25 billion.  However, given the relentless decline of AOL's subscription revenue, we believe the market would primarily value the company based on its media business.  An EBITDA multiple of 10X-15X applied to the $900 million 2008 EBITDA estimate for the media business yields a divisional value of about $9-$13 billion.  This is in line with our previous estimate. 

This EBITDA range depends on AOL's ability to keep the media business headed in the right direction: solid year-over-year growth in advertising revenue, combined with pageview and user growth on the owned-and-operated properties. If either of these drivers flag, the business will be worth less than 10X EBITDA.

Summary:

• We expect AOL division revenue will drop from about $5 billion in 2007 to about $4 billion in 2008, with most of the decline coming from additional subscriber losses.
• We project that AOL will increase advertising revenue 15% in 2008, from $2.3 billion to $2.6 billion, partially driven by improved remnant CPMs from the network strategy.
• We project that overall divisional EBITDA will remain approximately flat in 2008 at about $1.7 billion.

Assumptions:

• We assume subscription revenue will drop from $2.5 billion in 2007 to $1.4 billion in 2008
• We assume that quarterly cost will decline in Q107 just over 20% from Q207 levels of $768 million to $600 million.