AOL Patent Deal Isn’t Enough to Satisfy Activist Fund

Hedge fund Starboard Value applauds AOL’s new patent agreement with Microsoft but presses for more action to unlock shareholder value.


AOL’s decision Monday to sell more than 800 patents to Microsoft for $1.06 billion is in line with earlier recommendations from Starboard Value, a $1 billion hedge fund that has launched a proxy fight against the Internet and content company. Under the deal, AOL also has granted Microsoft a nonexclusive license to its retained portfolio of more than 300 patents and patent applications covering categories including advertising, search, social networking, content generation/management and mapping, among others.

Investors apparently liked AOL’s announcement, sending the stock up 45 percent on the day.

“We commend management and the board for taking this meaningful first step in unlocking value for AOL shareholders,” Jeffrey Smith, managing member of Starboard Value, said in a statement. Starboard owns 5.3 percent of AOL’s stock and has been pushing the company to take steps to boost the stock’s value since at least December 21, 2011.

The company said in a press release that the patent sale resulted from what it calls “a robust auction process” for the patent portfolio. “The combined sale and licensing arrangement unlocks current dollar value for our shareholders and enables AOL to continue to aggressively execute on our strategy to create long-term shareholder value,” said Tim Armstrong, AOL’s chairman and CEO.

AOL still has a way to go to satisfy the hedge fund, however.

For one thing, Starboard wants AOL to exploit potential tax benefits from its past failures. More specifically, the fund wants the Internet company to shield gains from the sale of the patents with tax savings that can be mined from previous deals in which the company overpaid.

“Before AOL finalizes any deal to sell low tax basis assets, such as its patents or the access business, we urge the company to review its portfolio of high tax basis assets and explore opportunities to divest such assets in order to offset the potential tax liability,” Starboard recently stated in a regulatory filing.

The fund cited as examples AOL’s acquisition of Moviefone in May 1999 for $525 million and MapQuest in December 1999 for $1.1 billion.

Chances are AOL would only fetch a fraction of that amount for those assets, which would generate significant net operating losses, capital loss carryforwards or both that could be used to offset gains on other asset sales.

Monday’s deal seems to have generated some of these benefits. AOL said that it expects to use about $40 million of existing deferred tax assets, representing 20 percent of its total, to offset taxes resulting from the license of its remaining patent portfolio.

In a letter to AOL’s board on Tuesday morning, however, Starboard’s Smith asserted that AOL still has a lot more to do to unlock value, citing the company’s “poor operating performance and substantial losses” in the display business.

Starboard points out that the business is currently losing over $500 million per year, including $150 million alone in Patch, an online site that offers tailored content on a neighborhood-by-neighborhood basis. Starboard figures AOL’s consolidated ebitda of $387.5 million in fiscal 2011 would have been $932.5 million if losses from the display business were excluded.

The hedge fund is also concerned that AOL will fritter away the cash it receives when the patent deal closes. It estimates the company will then have about $1.43 billion of cash, or $15.35 per share, which represents more than half of AOL’s current market capitalization.

AOL said in the release announcing the patent sale that it plans to return “a significant portion of the sale proceeds to shareholders,” although it did not specify how or how much. This fell far short of what Starboard wants. “We do not understand why the company would only return a ‘significant portion,’ Smith wrote in his letter. “Why wouldn’t the company simply return all of the proceeds?”

The Starboard executive went on to say he fears the money will be used for “poorly conceived acquisitions and investments into money-losing initiatives,” such as Patch. The fund notes that the $2.3 billion AOL has spent on acquisitions since 1999 resulted in a goodwill impairment charge of $1.4 billion during 2010 alone.

“There remains a substantial opportunity to unlock shareholder value at AOL,” Smith added. “The announced sale of AOL’s patents does not address the need for substantial improvement in the operating performance of the company.”

In the meantime, Smith stressed that soon Starboard will file preliminary proxy materials for the election of its director nominees to the AOL board at the upcoming annual meeting.

Despite the patent sale and 45 percent stock rise, this battle has only just begun.