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PART I - ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS(Edgar Glimpses Via Acquire Media NewsEdge) You should read the following discussion of our results of operations and financial condition together with our condensed consolidated financial statements and the notes thereto included elsewhere in this Quarterly Report as well as the discussion in the "Item 1-Business" section of our Annual Report. This discussion contains forward-looking statements that involve risks and uncertainties. The forward-looking statements are not historical facts, but rather are based on current expectations, estimates, assumptions and projections about our industry, business and future financial results. Our actual results could differ materially from the results contemplated by these forward-looking statements due to a number of factors, including those discussed in "Item 1A-Risk Factors" in our Annual Report and herein and "Cautionary Statement Concerning Forward-Looking Statements" herein. Introduction Management's discussion and analysis of financial condition and results of operations ("MD&A") is a supplement to the accompanying condensed consolidated financial statements and provides additional information on our business, recent developments, results of operations, liquidity and capital resources and critical accounting policies. MD&A is organized as follows: • Overview. This section provides a general description of our business and recent developments we believe are important in understanding our results of operations and financial condition or in understanding anticipated future trends. • Results of operations. This section provides an analysis of our results of operations for the three and nine months ended September 30, 2014 and 2013. • Liquidity and capital resources. This section provides a discussion of our current financial condition and an analysis of our cash flows for the nine months ended September 30, 2014 and 2013. This section also provides an update to the discussion in our Annual Report of our customer credit risk and includes a discussion of the amount of financial capacity available to fund our future commitments and ongoing operating activities. • Critical accounting policies. This section identifies those accounting policies that are considered important to our results of operations and financial condition and require significant judgment and estimates on the part of management. 2-------------------------------------------------------------------------------- Table of Contents AOL INC. PART I - ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Overview Our Business We are a leading global media and technology company with a substantial worldwide audience and a suite of digital brands, products and services that we offer to consumers, advertisers, publishers and subscribers. We are focused on attracting and engaging consumers by creating and offering high quality branded online content, products and services and providing valuable advertising services on both our owned and operated properties and third-party websites. We market our offerings to advertisers on both AOL Properties and on third party properties (the "Third Party Platform"). AOL Properties include our owned and operated content, products and services in the Membership Group and Brand Group segments, which are each described in further detail below. AOL Properties also include co-branded websites owned or operated by third parties for which certain criteria have been met, including the requirement that the internet traffic has been assigned to us. Through AOL Platforms we provide third party publishers with premium products and services, such as video and custom content production, intended to make their websites attractive to brand advertisers, in addition to offering ad serving and sales of third party advertising inventory. Our AOL subscription service, which we offer consumers in the United States for a monthly fee, is a valuable distribution channel for AOL Properties. Our business is organized into three reportable segments: the Brand Group, the Membership Group and AOL Platforms. In addition to these reportable segments, we have a corporate and other category that includes activities that are not directly attributable or allocable to a specific segment. Brand Group The Brand Group consists of our portfolio of distinct and unique content and certain service brands. The results for this segment include the performance of our advertising offerings on a number of owned and operated sites, such as AOL.com, The Huffington Post, TechCrunch and MapQuest. The Brand Group also includes co-branded websites owned or operated by third parties for which certain criteria have been met, including the requirement that the internet traffic has been assigned to us. We generate advertising revenues from the Brand Group through the sale of display and search advertising. Display advertising revenue is generated by the display of graphical advertisements and other performance-based advertising. We offer advertisers marketing and promotional opportunities to purchase reserved placements of advertising directly on sites within the Brand Group in particular locations and on specific dates. In addition, we offer advertisers the opportunity to bid on unreserved advertising inventory on Brand Group sites utilizing our proprietary scheduling, optimization and delivery technology. We collectively refer to revenue associated with these offerings as premium display advertising revenue. Finally, advertising inventory on Brand Group sites not sold directly to advertisers, as described above, may be included for sale to advertisers with inventory purchased from third-party publishers through AOL Platforms. Amounts received from external customers for inventory sold through AOL Platforms are recognized in AOL Platforms with a corresponding intersegment traffic acquisition costs ("TAC") charge. An amount equal to the TAC charge for these transactions, reflecting the revenue net of the margin retained by AOL Platforms, is then reflected as intersegment revenue within the Brand Group. Search advertising revenue is generated when a consumer clicks on a text-based advertisement on Brand Group sites. These text-based advertisements are either generated from a consumer-initiated search query or placed on sites targeted by advertisers based on the content of the websites. While the majority of our search revenues are reflected within the Brand Group, there are also search revenues within the Membership Group for search offerings provided in that segment. 3 -------------------------------------------------------------------------------- Table of Contents AOL INC. PART I - ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Membership Group The Membership Group consists of offerings that serve our registered account holders, both free and paid. The Membership Group creates integrated experiences that allow our consumers to have access to useful content from important brands, communication tools and valuable services. The results for this segment include our subscription offerings and advertising offerings on Membership Group properties, including communication products such as AOL Mail. In addition, we offer new products and services that are either third party or AOL-developed products. We earn performance-based fees in relation to marketing third party products and services. We offer these products to our current and former subscribers as well as other internet consumers. As with the Brand Group, advertising inventory on Membership Group sites not sold directly to advertisers may be included for sale to advertisers through AOL Platforms and is reflected as intersegment revenue within the Membership Group. Search offerings are also provided on Membership Group properties. AOL Platforms AOL Platforms consists of interconnected programmatic, video and other premium advertising offerings that advertisers and publishers use to reach consumers across all devices (i.e., desktop, mobile, tablet and internet-enabled television) and includes formats such as display, video and social. AOL Platforms offerings enable publishers and advertisers to utilize Third Party Platform inventory as well as AOL's inventory within the Brand Group and Membership Group sold by AOL Platforms. The results for this segment include the performance of Advertising.com, AOP, Adap.tv, Marketplace, ADTECH, AOL On, Be On and Convertro. We generate advertising revenues on AOL Platforms through the sale of advertising on third party websites and from advertising inventory on AOL Properties not sold directly to advertisers, as described above. Recent Business Initiatives The online display advertising market has experienced an increase in programmatic buying of advertising inventory. We continue to invest in programmatic technology, such as our demand side and supply side platforms, in order for advertisers and agencies to better manage their advertising campaigns through the use of our optimization technology. We believe there is a significant opportunity to attract advertisers through the increased sale of premium formats, including video, through AOL Platforms. We believe our scale, ability to target premium audiences and investments in technology and premium formats will allow us to increase the number of advertisers we work with and enable us to capitalize on the increase in programmatic buying. We believe our investments in premium formats and targeting will enable us to maximize yield for our advertisers. Revenues from the sale of our programmatic offerings are primarily reflected in AOL Platforms results. We have different cost structures within our advertising operations. In order to generate advertising revenues on AOL Platforms, we have historically had to incur higher TAC as compared to advertising revenues generated on Brand Group or Membership Group properties. While a majority of the costs associated with generating advertising revenues on AOL Platforms are variable, a majority of costs associated with generating advertising revenues on Brand Group and Membership Group properties are fixed. Therefore, to the extent we can generate higher revenues on Brand Group and Membership Group properties where we expect higher incremental margins, the increase in adjusted operating income before depreciation and amortization ("Adjusted OIBDA") will be greater than it would be with an equivalent increase in advertising revenues on AOL Platforms. Similarly, we have recently increased our marketing efforts related to search in order to drive increased usage of our search products across the internet. Due to the higher TAC incurred associated with these additional marketing efforts, search revenue generated as a result of these marketing efforts results in a lower margin than revenue generated by a user coming directly to our products. 4 -------------------------------------------------------------------------------- Table of Contents AOL INC. PART I - ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS We believe that video enhancements across our owned and operated properties and third party websites can enhance our advertising product offerings and increase monetization and distribution of our content. We seek to launch new format enhancements, increase advertiser adoption of these formats and attract additional publishers. We aim to create products that will deepen our relationships with existing advertisers and attract new advertisers by providing them with effective and efficient means of reaching targeted audiences through premium video experiences. We remain focused on the continued expansion of our video platform for both our properties and our partners. Through our video platforms we offer advertisers, publishers and agencies a means of planning, buying and measuring video advertising programmatically across the internet, television and mobile video. Recent Developments 2014 Stock Repurchase Program On July 28, 2014, our Board of Directors (the "Board") approved a new stock repurchase program (the "2014 Stock Repurchase Program"), which authorizes us to repurchase up to $150.0 million of our outstanding shares of common stock from time to time over the twelve months following the announcement of the program, depending on market conditions, share price and other factors. The repurchases may be made in accordance with applicable securities laws in the open market, in block trades, pursuant to pre-arranged trading plans or otherwise and may include derivative transactions. The 2014 Stock Repurchase Program may be suspended or discontinued at any time. During the three months ended September 30, 2014, we repurchased a total of 0.9 million shares under the 2014 Stock Repurchase Program at a weighted-average price of $42.46 per share (approximately $40.0 million) following the issuance of our convertible senior notes discussed below. Sale of Dulles Technology Center On July 30, 2014, we completed the sale of a data center property located in Virginia for cash of approximately $33.1 million, net of costs to sell the property. The proceeds were used for general corporate purposes. We recorded an immaterial loss on sale in the third quarter as the carrying value approximated the net sale proceeds. Revolving Credit Facility On August 4, 2014, we repaid $30.0 million of borrowings under our Credit Facility Agreement. We repaid the remaining $75.0 million outstanding on September 11, 2014, using a portion of the proceeds from the convertible senior notes discussed below. At September 30, 2014, and to date, we have no amounts outstanding under our Credit Facility Agreement. Convertible Senior Notes On August 14, 2014, we issued $379.5 million aggregate principal amount of 0.75% convertible senior notes due September 1, 2019 (the "Notes") through a private placement. We sold the Notes under a purchase agreement, dated August 13, 2014, with Goldman, Sachs & Co. ("Goldman Sachs") and J.P. Morgan Securities LLC ("J.P. Morgan") as representatives of the several purchasers (the "Initial Purchasers"). The Notes were issued under an indenture, dated as of August 19, 2014 (the "Indenture") between the Company and The Bank of New York Mellon, as trustee. The net proceeds from our sale of the Notes were approximately $369.1 million, net of issuance costs of $10.4 million. We used $40.0 million of the net proceeds from this offering to repurchase shares of our common stock from the purchasers of Notes in this offering in privately negotiated transactions through Goldman Sachs as our agent. These repurchases are part of the 2014 Stock Repurchase Program discussed above. We used $75.0 million of the net proceeds to repay borrowings under the Credit Facility Agreement discussed above. We used $36.6 million 5 -------------------------------------------------------------------------------- Table of Contents AOL INC. PART I - ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS of the net proceeds to pay the net cost of convertible note hedge and warrant transactions designed to, among other things, offset our exposure to potential dilution and/or amounts we are required to pay on conversion of the Notes. We expect to use the remaining net proceeds from the offering of the Notes for general corporate purposes including, but not limited to, additional share repurchases, acquisitions or other strategic transactions and working capital. See "Note 5" in our accompanying condensed consolidated financial statements for more information on the Notes and the convertible note hedge and warrant transactions. Key Metrics Key indicators to understanding our operating results include: • Advertising revenues, net of traffic acquisition costs; • Unique visitors; • Subscription revenue; and • Our ability to manage our cost structure. Audience Metrics We utilize unique visitor numbers to evaluate our performance, as unique visitor numbers provide an indication of our consumer reach. Although our consumer reach does not correlate directly to advertising revenue, we believe that our ability to broadly reach diverse demographic and geographic audiences is attractive to brand advertisers seeking to promote their brands to a variety of consumers without having to partner with multiple content providers. Multi-platform unique visitor metrics represent a measure of AOL Properties' unduplicated audience across multiple digital platforms (desktop computers, smartphones and tablets). AOL multi-platform unique visitors represent the estimated number of individuals who visited any content of a website or application owned by AOL or for which the traffic has been assigned to AOL by the owner during the applicable measurement period. Additionally, AOL multi-platform unique visitor metrics also include visitors to AOL's syndicated video content distributed on third party sites. Desktop unique visitors to AOL Properties represent the estimated number of individuals who visited any content of a website or application owned by AOL or for which the traffic has been assigned to AOL by the owner during the applicable measurement period via a desktop computer. AOL Properties unique visitor numbers include unique visitors attributable to co-branded websites owned by third parties for which certain criteria have been met, including the requirement that the internet traffic has been assigned to us. For the three months ended September 30, 2014, approximately 9.6% of our desktop unique visitors to AOL Properties were attributable to co-branded websites owned by third parties where the internet traffic was assigned to us, compared to approximately 8.6% for the three months ended September 30, 2013. The source for our unique visitor information is a third party (comScore Media Metrix). 6 -------------------------------------------------------------------------------- Table of Contents AOL INC. PART I - ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS The following table presents our unique visitor metrics for the periods presented (in millions): Three Months Ended Nine Months Ended September September 30, 30, 2014 2013 2014 2013 Domestic average monthly AOL multi-platform unique visitors 179 156 173 145* Domestic average monthly desktop unique visitors to AOL Properties 108 115 110 114 * Nine months ended September 30, 2013 represents a monthly average for February through September 2013, as comScore only began reporting the multi-platform metric in February 2013. Subscriber Metrics The number of domestic AOL subscribers was 2.3 million and 2.5 million at September 30, 2014 and 2013, respectively. Average monthly subscription revenue per AOL subscriber ("ARPU") was $21.35 and $20.54 for the three and nine months ended September 30, 2014 compared to $20.15 and $19.80 for the three and nine months ended September 30, 2013. We include in our subscriber numbers individuals, households and entities that have provided billing information and completed the registration process sufficiently to allow for an initial log-on to the AOL access service. Our subscriber numbers include subscribers participating in introductory free-trial periods and subscribers that are paying no monthly fees or reduced monthly fees through member service and retention programs. Individuals who have only registered for our free offerings, including subscribers who have migrated from paid subscription plans, are not included in the AOL subscriber numbers. Additionally, only those individuals whose subscription includes AOL-brand dial-up access service are included in the AOL subscriber numbers. Subscribers to our subscription access service also contribute to our ability to generate advertising revenues. The primary non-financial metrics we monitor for our subscription service are monthly average churn and average paid tenure. Monthly average churn represents on average the percentage of AOL subscribers that are either terminated or cancel our services each month, factoring in new and reactivated subscribers. The domestic AOL subscriber monthly average churn was 1.4% for both the three months ended September 30, 2014 and 2013. Average paid tenure represents the average period of time individuals have been AOL subscribers. The average paid tenure of the remaining domestic AOL subscribers has been increasing, and was approximately 14.1 years and 13.0 years for the three months ended September 30, 2014 and 2013, respectively. 7 -------------------------------------------------------------------------------- Table of Contents |