You don't need corporate raider Carl Icahn whispering in your ear to know that Time Warner's (NYSE:TWX) America Online division has been a hotbed of blunders in recent years. Just hang out by the logoff screen. Since its usage peaked in September of 2002 with a subscriber base of 26.7 million users, every quarter has seen the once high-flying service's membership slide. Right now, the warm bodies stand at 20.8 million, and the defections are likely to continue in the short term.
Why? Well, while AOL has tried to package value into its premium-priced subscriber plans, it has also done its best to unscrew the training wheels that drove many users to AOL in the first place. Getting rid of its proprietary newsgroup reader or ditching its fast-loading message-board platform in favor of a Web-enabled slowpoke will only further fuel the exodus.
AOL has dared its subscribers to leave to faster or cheaper access elsewhere. The taunts have been successful. As a result, AOL has been hard at work beefing up its AOL.com portal as a catchall destination for all of the wired world's nomads. Internet advertising continues to gain traction with sponsors, and AOL has been served well by broadcasting Google's (NASDAQ:GOOG) paid-search results in exchange for a significant piece of the action. That's the reason that last week's report in The New York Post, claiming that Microsoft (NASDAQ:MSFT) is looking to snap up a piece of AOL, is so disturbing.
The problem with Mr. Softy
The balance sheets suggest that this would be a pairing made in partnership heaven. Microsoft's packing tons of cash, while Time Warner's got $19.4 billion in long-term debt wrapped around its neck like a lanyard on a tourist.
The size and scope of this potential deal remains to be seen. Whether Microsoft kicks some greenery into Time Warner's coffer in exchange for a minority stake in AOL, or whether it all evolves into a much grander soiree, what's clear is that Microsoft's intentions are twofold. Yes, it would love to have the eyeballs that go to AOL. However, just as important would be supplanting Google as AOL's contextual-advertising partner.
That could be a problem. Over the past year, Microsoft's flagship MSN site has generated just $1.4 billion in advertising. Over the past four quarters, meanwhile, Google has generated enough leads to move $4.4 billion worth of online ad sales. The disparity is even more surprising when one considers that MSN is generating more page views and holding its unique visitors longer.
However, those sums should probably come with a litany of asterisks and clarifications. For starters, Google's bread-and-butter search engine will always be more lucrative than Microsoft's collection of pages. That's because it's harder to monetize free email pages, software upgrades, or news updates with targeted text ads. Google also serves its ads on third-party sites -- such as AOL -- making its reach far wider than just to its namesake domain.
However, that doesn't explain away the fact that Google is very generous with the third-party sites that serve up the company's AdWords ads. This past quarter, 67% of the revenue generated from these click-throughs went right back to the publishers. That figure includes many smaller sites in the AdSense program, meaning that Google's payout ratio is actually higher than that for its prime accounts. Reports have AOL's cut running closer to 80%.
And that's what makes hooking up with Microsoft as its ad supplier potentially dangerous. Receiving 80% out of Google's proven ad program may very well amount to more than even 100% for Microsoft. Yahoo! (NASDAQ:YHOO) acquired Overture, the paid-search pioneer, and even Yahoo! isn't selling as many targeted ads as Google is.
It may therefore appease Time Warner investors in the near term to see AOL receive a cash infusion from Microsoft, but the eventual fruit of that labor may not appear as tasty.
Yes, Microsoft hates Google
Google scares a lot of bellwethers, especially Microsoft. While Microsoft won its audience by default, piggybacking its brand ambassadorship on every Windows-enabled computer around, Google has earned every home-page bookmark. There is no pre-installed AdWords application in every small-business-loan submission. Things like AdWords and Google Earth became electively popular.
In short, Google is king, but it won that honor as a write-in candidate. That's noble. That's cool. That's dangerous if you're anybody other than Google.
Microsoft can compare its battle with Google to the way it fought against IBM (NYSE:IBM), but that's naive. That was when Microsoft was in its prime, tackling a dinosaur with broken bifocals. The Microsoft of today is a watchdog magnet. The Microsoft of today is lethargic, having grown sales this past fiscal year by a mere 8%. Beyond its core software competencies, the Microsoft of today is a follower that chases Sony (NYSE:SNE) in the video game market and Apple Computer (NASDAQ:AAPL) in digital music. The one thing that Microsoft is not is the Microsoft of yesterday. It can't just don the gloves and dance around the ring anymore.
And so we come to Microsoft needing AOL -- only it would be doing so strictly for the real estate. AOL needs to be careful here. It still has time to make itself something more than just someone else's fixer-upper.
Time Warner shares have risen by 44% since being singled out in Motley Fool Stock Advisor three summers ago. Want more market-thumping picks? Check out a 30-day free trial offer.
Longtime Fool contributor Rick Munarriz has been an AOL subscriber since 1992 -- and speaking Spanish since he was born -- but he doesn't own any of the stocks mentioned in this story. The Fool has a disclosure policy. Rick is also part of the Rule Breakers newsletter research team, seeking out tomorrow's ultimate growth stocks a day early.
