Is it time to dial up AOL or hang up?

NEW YORK, USA: When AOL Inc AOL.N Chief Executive Tim Armstrong rings the opening bell of the New York Stock Exchange on Thursday, he hopes to put behind one of the most disastrous mergers in corporate history.

The question is whether investors will take to the newly independent Internet company, especially since the spin-off was structured so the first holders of the stock are Time Warner Inc shareholders.

Armstrong wants to reposition AOL as an online content and advertising play - whose rivals include Google Inc and Yahoo Inc - but the company is still dependent on cash generated by its dwindling dial-up Internet access unit.

The spin-off gave Time Warner shareholders an AOL stock dividend for every 11 shares of Time Warner. Based on the Time Warner's closing share price on Nov. 16, when the plan was announced, AOL's market value was worth just over $3 billion.

But since AOL has been trading on a 'when issued' basis, its value has fallen to around $2.4 billion.

Is AOL now a good buy, considering it was valued as high as $163 billion in January 2000, when the Time Warner merger was announced?

Good valuation

Looking at current 'when issued' valuations, Collins Stewart analyst Thomas Eagan thinks there might be an opportunity. Collins Stewart compared AOL's access business with the valuations of peers such as United Online Inc and EarthLink Inc, using a ratio of enterprise value per subscriber.

"We think AOL's access business alone, which has 4.9 million subscribers, is worth $2.2 billion. This means that you're getting the AOL portal business and all the brands for less than $300 million," Eagan said.

He also thinks Wall Street may have underestimated the earnings boost from restructuring efforts that Armstrong's team have undertaken.

"A lot of folks aren't giving them credit for the $300 million savings next year and likely more in 2011," he said.

Todd Rethemeier, an analyst at Hudson Square Research, thinks most of the bad news about AOL is already known, such as the slump in advertising spending and the declining dial-up access business.

"There were a lot of things wrong with AOL, which are already priced into its current valuation," said Rethemeier, who has a 'hold' rating on AOL for when it starts trading on Thursday.

"Tim Armstrong is setting the bar pretty low. The question is how quickly can they turn around the advertising business."

Wait before you dial

Others say the very nature of AOL's spin could work against it. The shareholders it inherited from Time Warner include funds that a newly independent AOL might not meet the requirements of their charters.

"There are some funds out there that may have to sell AOL off," said Chris Marangi, an analyst at Gabelli & Co, a long- time holder of Time Warner. "They may be restricted in what they can own in terms of market cap or they may be required to own dividend payers for example."

These kinds of dynamics could put undue pressure on the stock, said Colin Gillis, an analyst at Brigantine Advisors.

"Many Time Warner holders are mostly not going to want this. It's going to be driven more by the machinations of the spin," he said.

Value investors may be disappointed by AOL unless they are prepared to stay for the long haul, Gillis said, as Armstrong will likely plunge cash back into the business rather than issue dividends or share buy backs.

"The problem is near-term holders have an incentive to sell and buyers have an incentive to wait to see how Tim and the stock perform," he said.

Broadpoint analyst Benjamin Schachter said in a note there is potential upside if AOL can get its advertising margins in line with peers such as Yahoo, but he was worried about audience losses due to declines in its access business.

Armstrong said on Wednesday that access subscribers account for a "minority" of its customer traffic.

"We simply think it may be a long wait before overall margins might improve," said Schachter. "The bottom line is that, while shares of AOL may look attractive on a comparative multiple basis, we recommend investors wait for a more compelling entry point."