The latest report covering the KKR buyout of First Data is disturbing at several levels.  It is a clear demonstration that the buyout model of the last 2-3 years is over – the debt markets have dried up for this sort of lower quality paper. Does this mean buyouts will disappear?  No – I just think you will see a return to the model championed by Silverlake and others in less buoyant times: Buy what you think are solid-fundamentals quality firms with growth potential (e.g., Seagate), then help get them the operational talent they need to take their game to a new level. We saw a number of marginal buyouts happen over the last two years (I am not trying to paint First Data with this brush) – that’s over for the foreseeable future. The major banks are, as mentioned in the WSJ article, caught in-flight with a commitment of their balance sheets to some of the major buy-out firms, with little or no chance of placing that paper without a SERIOUS haircut.

With the drying up of liquidity, the future for AOL is now made much more complex. There were lots of folk betting on a private equity consortium stepping in to take AOL of TWX’s books. That path now has little or no chance of succeeding in this environment.

What next then for AOL? I am not sure. Under the assumption that the aggregate AOL entity moves into a model of flat to low single digits growth, I am not sure TWX can afford to continue to have it roll up into the aggregate numbers. It makes TWX’s ability to position itself as a 10+% annual growth business a real challenge. If we assume that some structural move is in AOL’s future, what are left as options? Most of the prior musing about AOL has its future going down one of five paths:

1. Acquisition by Microsoft

2. Acquisition by Yahoo

3. Acquisition by Google

4. Standalone spinout as public entity

5. Sale to private equity player.

I think all of these options have way too much hair on them. Buying all of AOL brings a lot of financial baggage with it. To begin the dialog, let me give you my view on AOL and its composite parts. AOL is essentially composed of three major segments (this is not how things are necessarily organized, but is the best way to discuss its valuation):

AccessCo – this is the remnant primarily-dial-up access business. It is a great source of free cash, now that the marketing spend has been dialed back to practically zero, but as the last quarter showed, it is on a pretty fast decline (10% subscriber declines in the quarter), and should be modeled and valued appropriately. To me, on a discounted cash flow basis, maybe it is worth $3.5B-$4B (this is a rough justice estimate, given analyst views on sub profitability and an extrapolation of subscriber trends), assuming there is some tail of folk who will stay customers till the end (like what we saw with Compuserve).

PublishCo – these are all the properties that generate the viewership traffic for AOL to monetize. This is a collection of a lot of disparate assets, ranging from things like AIM and MapQuest to the AOL 9.0 user base. Most of PublishCo is best described as Web 1.0 in nature (no franchise model), with the exception of businesses like Userplane. Valuing PublishCo is difficult – The aggregate US pageviews and engagement metrics are pretty huge, but the trajectory is relatively flat, and even with an optimistic lens, it is most probably a low single digits growth business.

AdCo – these are the operations for monetizing the traffic of both PublishCo and third party inventory. I am putting the search operations in here as well. The centerpieces for AdCo are Advertising.com and AOL’s ad sales force. AdCo has been expanded over the last year through acquisitions like Lightningcast, Third Screen Media, Tacoda, and AdTech AG. Performance of elements of AdCo are pretty stunning. On last quarter’s earnings call, Dick Parsons mentioned sales on third party inventory (versus PublishCo’s) were up 32% year over year. This is driven in large part by the performance at Advertising.com. Valuing AdCo is probably the heart of matter in determining AOL’s future. If you focus on the display ad sales business, solving for a combination of sales within AOL’s own properties and sales on third party sites, you can craft a business of 20+% annual growth, with decent, if not exceptional margins. Adding the AOL search business into the mix gives you a lower growth top line story (the 16% year-over-year growth highlighted in last quarter’s financials), but dramatically improved margins, given the sweet economics of the deal with Google. The structural thinking here is the biggest leverage point in any AOL valuation dialog. It’s well worth the effort – if we use the Microsoft acquisition of aQuantive for $6B earlier this year as a comp, some permutation of AdCo (Advertising.com, the search business, a multiyear commitment by TWX to rep the inventory of PublishCo) could be valued at $10+B, assuming the parts hit the magic 20+% annual growth bogey.

So if these are the pieces and parts, what do you do as the parent?

Cowboy up and stick to the script of giving AOL runway to validate its strategy? I think we are rolling down the runway at 220 mph and have about 1000 feet left. Given the lukewarm feedback to the announcement of the $5B in additional stock buyback and the increase in dividend (the TWX stock closed today at 18.66), time is running out for management to remain masters of their own domain. The harsh words by Pali analyst Rich Greenfield are a shot across the bow – the buy side is losing patience. The only question is who is going to play the role of Carl Icahn this time around.

Sell the aggregate entity? I just don’t think that is something that will attract lots of attention. The three majors (Google, Microsoft and Yahoo) wouldn’t want the mass of no-growth components that the aggregate entity brings with it. How many acquisitions bring with them an immediate establishment of a sizable discontinued operations (AccessCo)? Maybe you could see a three party transaction, where the acquirer immediately lays off the declining cash cow to a private equity player…

Sell/spin AdCo? I think this is an attractive path. TWX retains AccessCo in its discontinued operations segment, and uses the free cash generated for more strategic purposes. AdCo is either sold to one of the majors (let’s add Murdoch and Diller to this list), or spun out to create a growth multiple currency to continue to roll up properties. AdCo is a really complementary acquisition by almost every major player out there (unlike what buying the assets of PublishCo would mean to a Yahoo or Microsoft). It also can survive and thrive in a world of disaggregation of traffic (i.e., it’s not a Web 1.0 bet on portals).

What about PublishCo? There are interesting properties (MapQuest, AIM, etc.) that are worth decent valuations. I just think dealing with PublishCo in the same time horizon as AdCo is a tough act. Perhaps Day 1, PublishCo might be combined with other web properties in the TWX family and given a longer event horizon to determine its course. The other option might be a separate aggregate sale to a player with greater web aspirations (e.g., Comcast). I struggle here on an elegant solution for this, but I think PublishCo’s valuation isn’t the big dial to turn in an AOL discussion – it just doesn’t have legs as part of a growth story. You do need the commitment from PublishCo for AdCo to run its inventory (and its search traffic) for 5 years to make the story all hold together, but I think that’s about the full extent you’d want the operational interop between AdCio and PublishCo.

I am a TWX stockholder, and the retreat to 18.66 pains me. I just don’t see an organic path to material success (i.e., 10+% annual growth) for AOL in its existing form, given current course and speed. In this world of inflated valuations and TWX’s commitments to stock buybacks consuming the available cash for acquisitions, too many deals will trade away that would help AdCo continue its forward momentum. With all the talk about arming AOL with its own currency over the last few years, it’s time to make it a reality – it just needs to take another form – AdCo currency.