AOL (NYSE:AOL) delivered third quarter earnings Nov. 6 prior to the open. The content provider delivered revenues and earnings that beat analyst expectations, sending its stock skyward, up more than 20%. Under CEO Tim Armstrong, the company's turnaround continues to gain ground. Up more than 150% year-to-date, its stock trades at the highest point since its spin-off from Time Warner (NYSE:TWX) in 2009. While the earnings report definitely had some negatives, its future appears much brighter today than when Armstrong took the job in April 2009.

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The Report Itself

  • Revenues in the third quarter were $532 million compared to the analyst consensus estimate of $522 million.
  • Its non-GAAP earnings per share were $0.34, seven cents higher than what analysts were expecting.
  • Earnings per share (EPS) improved by 24 cents to $0.22 from a two-cent loss last year.
  • Free cash flow (FCF) increased 27% in Q3 to $71.5 million.
  • Global advertising revenues increased 7% year-over-year to $340 million, its best growth in more than seven years.
  • Traffic to its sites grew 4% year-over-year to 111 million unique visitors every month, up from 107 million in Q3 2011.
  • Patch, which many liken to the Titanic, saw its traffic grow by 19% year-over-year to 11.9 million unique visitors.

About the only downer was the 3% drop in domestic display advertising, which represents just a $3.3 million decrease in terms of dollars. Tim Armstrong summed it up best when he stated, "We just reported the best relative revenue performance in seven years and the second consecutive quarter of year-over-year profit growth, exceeding our expectations." AOL is happy with the quarter and investors should be too. This was a company on the brink less than two years ago.

SEE: How To Decode A Company's Earnings Reports

Tim Armstrong's big emphasis in the third quarter conference call was definitely video. Take Patch for example. Its coverage of Hurricane Sandy has included something like 14,000 articles and blog posts related to the devastation, leading to users uploading something like 10,000 photos and videos to the platform. Pictures indeed paint a thousand words. Whether you agree with Patch's content or not, this kind of local coverage is essential to every community in America, and video only enhances that. According to Armstrong, AOL's video advertising revenue two years ago was $10 million. In 2012, it will deliver 10 times that. As a result of this increased emphasis on video, its library has grown from 30,000 videos two years ago to 450,000 today. Armstrong expects both these numbers to grow significantly in 2013. While many are concerned about the 3% drop in domestic display advertising, it appears likely that its monetization of video will more than offset any drop from traditional display ads in the future. Its long-term goal is to join Google (Nasdaq:GOOG) and Facebook (Nasdaq:FB) in capturing the advertising money that's going to move from TV over to mobile and desktop video. AOL appears to be acting as opposed to reacting and that's always a good idea.

Controlling Costs
By looking at AOL's 10-Q from the third quarter you'll find that with the exception of traffic acquisition costs (TAC), which rose due to increased third-party network advertising revenue, AOL reduced its costs of revenues in every category in both Q3 and for the first nine months of the year. As a result, they declined by 4% in the third quarter and by 2% for the year-to-date. Most importantly, cost of revenues as a percentage of overall revenue was 72% in the third quarter, 300 basis points lower than a year earlier. In addition, by holding the line on general and administrative costs in the quarter at 18% of revenue and reducing the amortization of intangible assets to 2% of revenue from 4% a year earlier, AOL was able to increase its operating margin by 800 basis points (BPs) to 8%. If it continues to monetize its video and premium display advertising through Project Devil and Pictela while keeping control of its costs, both fixed and variable, its earnings per share will increase dramatically.

SEE: A Primer On Investing In The Tech Industry

The Bottom Line
Tim Armstrong finished off the Q3 conference call by suggesting AOL will do fewer things in the future, preferring to focus on a few key areas and doing them really well. Isn't that what business is all about? In the short term, investors will face a decline in AOL's stock once the $5.15 special dividend is paid on Dec. 14. However, expect good things to come 2013.

At the time of writing, Will Ashworth did not own any shares in any company mentioned in this article.

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