In my opinion, AOL will eventually end up in bankruptcy, or selling off its parts as scrap. Its business strategy is seriously flawed. The plan at AOL is to milk the declining cash flow from dial-up subscribers to invest in Internet brands and content, which can be monetized via advertising.
In particular, the company is focused on local Internet content. If you have a high tolerance for corporate-speak, you can watch CEO Tim Armstrong describe the strategy to Bloomberg in 2010. And despite years of mediocre results, the strategy has not changed -- it's all about content, advertising, and local. The problem is, selling advertising around Internet content is brutally competitive, and the economics of local content don't work. If you have any doubt of this, just look at AOL's recent results -- after huge investments, its content business is unprofitable.
Content-driven Internet advertising is a brutal industry
There are virtually no barriers to entry to create content on the Internet. With a little sweat equity and tech savvy, anyone can create content on the Internet. The costs, if any, are minimal.
It's an amazing feature of the Internet, and it's been a vast boon to consumers. There are blogs and websites for every niche, and it's an incredible outlet for creative individuals -- many of whom do it for free as a hobby. This has created a major supply-and-demand imbalance in the Internet content business.
There's lots of people willing and able to supply content and draw an audience, but the supply of businesses willing to pay for advertising hasn't grown nearly as fast. It's economics 101 -- as supply outstrips demand, prices fall until they reach the cost of production. That's the economics of making content for the Internet.
Most will fail and, at best, the goal is to scrape by with fleeting attempts at brand development, innovation, superior operations, or lower cost structure. The companies that have thrived on Internet advertising haven't been content producers -- they've been platforms. The best example is, of course, Google, but even Yahoo! has stayed afloat is based on its platforms like Yahoo! Finance or Yahoo! Sports -- not its content.
The goal of becoming "the world's largest online content company" is foolhardy. AOL will never get an adequate return on all the money that it has invested in developing online content.
The economics of local content do not work
Leveraging the Internet to enable local content has been a Holy Grail for media and technology entrepreneurs for decades. It's been tried and failed so many times that's its probably worth admitting defeat, at least for AOL. Local ad-based content doesn't work because audiences are so small that it's not possible to cover the cost of content production. It's a noble vision, and it might happen some day. But AOL probably isn't going to be the company that cracks the code.
If anyone ever figures out the local content puzzle, it will be a nimble start-up with an innovative vision, luck, and a step forward in technology. AOL doesn't separate out the results for Patch, its local content business, but it has been a huge money-loser. According to estimates published in The Wall Street Journal, Patch spent $160 million in 2011 while generating very little revenue.
Last month, AOL decided to downsize Patch -- reducing staff, sites, and costs -- to improve profitability. I'm not sure if profitability at Patch is possible; more likely, it will continue generating losses. But rather than abandon his money-losing pet project and admit defeat, Tim Armstrong is going to keep it going (and probably lose more shareholder money).
AOL's flawed content strategy is destroying value
Last year, AOL's content business lost $33 million dollars. The year before, it lost $48 million. Those losses might be acceptable if AOL's content business were an early-stage venture that was growing rapidly and likely to become profitable at a certain size.
In fact, its business isn't growing at all -- it's been flat for the past three years. And even more distasteful is that AOL spent heavily, externally and internally, to build this collection of money-losing content businesses. The cost of Huffington Post alone was $315 million.
Foolish bottom line
AOL needs a radical change of strategy. It should shutter or scrap its losing content business. Cash generated from the dial-up business should be invested in more sustainable and profitable ventures. Failing that, it should be returned to shareholders.
Brendan Mathews is short shares of AOL. The Motley Fool has no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.