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AOL: For Once, A Smart Shopper


At Time Warner Inc. (TWX) they know something about troubled mergers. After all, the company has never recovered from the entertainment giant's disastrous 2001 coupling with America Online Inc. So critics sneered when Time Warner bought startup Advertising.com Inc. for $435 million in 2004. One newspaper dismissed Ad.com as a tool for spammers pushing penile enhancement.

Today that obscure startup may hold the key to AOL's future. On Aug. 2, Time Warner is expected to announce a plan to tie AOL's fate even more tightly to advertising, phasing out $2 billion a year in already-shriveling subscription revenue. Such a radical move would be unthinkable without Ad.com, which provides almost 20% of AOL's ad revenue. Its sales doubled to $259 million between 2003 and 2005.

Even with Ad.com, AOL's plan is a stretch. Ad.com will need phenomenal growth to cover just half the lost subscription profits. But without it, AOL would be toast. "If AOL had not purchased Ad.com, I don't think there would be an AOL today," says Jeff Lanctot, general manager of Avenue A/Razorfish, the largest Internet ad agency.

It's hard to dispute Ad.com's recent track record. The company buys ad space from 3,000 sites and resells it to about 500 clients, employing technology to steer ads to the users most likely to act on them. Nearly half of the growth in AOL's ad sales in 2005 came from this unit. Its partner sites reach 144 million Americans a month, says Ad.com President Lynda M. Clarizio, about 30 million of whom don't visit any AOL sites. And momentum is strong. In the first quarter of this year, Ad.com expanded a deal with its largest client, Apollo Group Inc., parent of the University of Phoenix. Industry insiders say the deal, whose details are secret, could bring in $300 million worth of ads over three years. "Ad.com has probably been the most successful acquisition in [AOL's] history," says AOL Vice-Chairman Ted Leonsis.

Now, Time Warner hopes Ad.com can solve two of AOL's biggest mistakes following the megamerger. The first was its failure to expand its advertising base. Prior to purchasing Ad.com, the company only sold ads on AOL.com, other company-owned sites, and the flagship AOL service. By contrast, Google Inc. (GOOG) sells both on Google.com and on sites owned by partners. Such alliances brought Google $928 million in ad revenue in the first quarter of 2006. AOL is starting to tap Ad.com's relationships, hoping to guide its advertisers' spending all over the Net.

AOL's other mistake was arriving late to the market for search-related Web ads, which it now sells only through a partnership with Google. AOL thinks the next big market is ads related to online video searches, which are not part of the Google deal. It wants to target ads embedded in streaming video, both at AOL's own Web sites and at partner sites.

PAY FOR WHAT YOU GET

Ad.com has been a hit because it practically invented a fast-growing form of Web promotion called cost-per-action ads. In the Web's beginning, advertisers paid publishers based on the number of people who saw the ads. That left advertisers holding the bag if nobody bought the products. Google and Yahoo! Inc. (YHOO) built a cost-per-click model, where advertisers pay for an ad only when a Web surfer clicks on it. Advertisers loved this, turning cost-per-click into a $5.1 billion business last year.

Ad.com's special twist is that it charges most advertisers only when a consumer takes a real action -- buying something, or giving the advertiser a phone number for a follow-up call. In a 2005 campaign for Volkswagen, for example, Ad.com got paid for the 19,000 consumers who configured their ideal Jetta at vw.com and 12,000 who requested more information. VW didn't pay for millions who saw the ad but didn't act on it. Ad.com Chief Marketing Officer Mollie Spillman says about half of the company's business is cost-per-action deals, with the rest coming from cost-per-click, consulting, and cost-per-thousand-viewers agreements.

Here's how the system works. Ad.com buys cheap space and then adds its own targeting technology, which uses the results of past ad campaigns to decide who should get current ads. The targeting lets Ad.com charge a premium. Competitors from aQuantive Inc. (AQNT) to MSN (MSFT) and Google are now experimenting with cost-per-action, angling for the $50 billion a year that companies spend on direct-response marketing.

So how much can Ad.com really do for AOL? Merrill Lynch & Co. (MER) analyst Jessica Reif Cohen estimates that within two years, AOL will lose up to $250 million in annual profit before noncash charges as a result of shrinking its subscription business. That's about 14% of AOL's earnings, far more than Ad.com can make up for, even with $300 million to $400 million in likely 2006 sales and margins in the high teens. AOL won't talk specifics, but for the plan to work, Ad.com would have to double its current profits a0nd AOL's fast-growing search-ad business would have to make up the rest. Piper Jaffray's Safa Rashtchy says AOL's shrinking audience is a bigger problem than Ad.com can solve. "It's not a panacea," he says.

But in Ad.com's Baltimore neighborhood, they know from tough fights, too. Just down the Patapsco River is Fort McHenry, where Francis Scott Key once watched a different army take a pounding. If Time Warner's darkest hours finally pass, maybe Ad.com will ensure that AOL's flag is still there.

By Timothy J. Mullaney


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