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How AOL could help Verizon change its business

Why would a wireless and broadband company like Verizon spend $4.4 billion on a digital media company like AOL? One word: Advertising

Wireless and broadband may be Verizon's bread and butter, but the company's future relies on finding new ways to make money from its network.

Verizon says its "principal interest" in AOL was the "ad tech platform that Tim Armstrong and his team have done a really terrific job building." Francois G. Durand,/Getty Images

And that's where the $4.4 billion acquisition of digital media company AOL comes in: A primary reason for the purchase is AOL's advertising platform, which automatically helps its business customers buy and sell online ads while it also collects data on consumers' browsing history. AOL's ad technology may be especially attractive to marketers because it also lets them see whether customers respond better to ads shown on smartphones than, say, computers and TVs.

Verizon hopes to use AOL's technology when it launches a streaming mobile video service later this year.

"For us, the principal interest was around the ad tech platform that Tim Armstrong and his team have done a really terrific job building," John Stratton, executive vice president and president of Verizon's Global Enterprise and Consumer Wireline business, said at an investor conference on Tuesday after the news was announced. "We really like the technology a lot and we think of it as a key enabler for us as we begin to generate revenue and value above the network layer."

Stratton's comment about getting sales "above the network layer" is telling. That's because mobile customers are spending less on their monthly service even as they burn through more data to stream video, share pictures and access apps on their smartphones and tablets. And it doesn't help that smaller rivals, such as T-Mobile and Sprint, are slashing prices and stealing customers from Verizon and and its chief rival AT&T. The dynamic threatens the existing business model for the two wireless giants, which together control access to 70 percent of the wireless market.

"These operators need to create new avenues of growth that don't rely on their network services, which is their predominant legacy business," said Bill Menezes, principal research analyst at market research firm Gartner.

The conundrum

AT&T, Verizon and other broadband providers like cable operators have anticipated this trend for years. All have spent the past decade upgrading their Internet connections to handle new content services, like video. It's why Comcast bought NBC Universal and why AT&T is spending $49 billion to acquire satellite TV provider DirecTV. And it's why Verizon has begun assembling the technologies it needs to launch a mobile video service to rival Netflix and Google's YouTube. The company last year bought Intel Media, a failed business from the chipmaker that aimed to develop TV products and services delivered over the cloud.

"Verizon's logic is why should Netflix, Google and Facebook make money delivering services like video, when we can do just as well as they can," said Roger Entner, an analyst with Recon Analytics.

Mobile advertising: The key to Verizon's success?

Providing video service isn't cheap. For one thing, it's expensive to license content. And for another, it's costly and technically tricky to deliver high-quality video feeds over mobile networks. That means subscriptions alone can't help Verizon increase its sales and profit. It also needs to attract lots of advertising dollars.

"By acquiring AOL, Verizon is pointing to a future where advertisers, rather than users, carry a heavier burden," Craig Moffett, an analyst with MoffettNathanson, said in a note to investors.

This is where AOL shines.

"This is about the ad tech assets. It's really the only thing about AOL that's strategic," said Brian Wieser, an analyst with Pivotal Research Group.

Over the past two years, the company has invested more than $500 million acquiring two companies focused on mobile ads. In 2013, it bought video ad marketplace company Adap.tv for $405 million, its biggest purchase under CEO Tim Armstrong, who was a former advertising guru at Google. Adap.tv so-called programmatic advertising -- helping marketers automatically buy and sell ad spots for the right viewers online.

And AOL last year bought Convertro for $101 million. Convertro helps businesses and their marketing departments understand what about their campaigns actually work.

AOL has also unified these technologies to make it easy for advertisers to market across devices and screens, said Lauren Fisher, an analyst with eMarketer.

"They've really positioned the company as one at the forefront for programmatic," she said. "They've done a lot to make cross-screen marketing a reality."

Verizon -- which commands a virtual ton of data from its mobile and television customers -- is already well-positioned to capitalize on AOL's programmatic technology: More data just makes the automated marketplace more effective at matching buyers and sellers of ads.

The content play

But AOL gives Verizon more than just advertising technology. It also provides valuable content for Verizon's emerging video service.

Over the past three years since AOL launched its AOL On online video network, it's added content. AOL On mostly comprises short-form content licensed from top-tier publishers like ESPN, the Wall Street Journal and Vogue. But it also includes movies, through a partnership with film studio Miramax, as well as clips from AOL's own original series. (Its "Park Bench with Steve Buscemi" was nominated for an Emmy award last year.)

AOL is now the third largest US online video content network after Google and Facebook, and is among the largest providers of premium streaming video content in the market. This could be a boon for Verizon and reduce expenses for programming costs. But the content could also help Verizon differentiate itself from its rivals and prompt consumers to pony up a premium for wireless service.

"Verizon is attempting to shift the wireless conversation for users from differentiation on the traditional metrics of network quality and coverage to a more consumer-friendly content offering that other providers can't match, " Moffett said.

"The strategy has the potential to drive not only usage but also market share in a way that is potentially more lasting and more fundamental than the string of more-data-for-less-money promotions that have dominated the past year."

But many observers think Verizon has little interest in AOL's editorial ventures, including Huffington Post, TechCrunch and Engadget. Recode reported that other acquirers are talking to the Huffington Post, the brand within the AOL publishing family with the broadest reach.

"Verizon has no use for the media properties," Entner said. "They'll sell them and make some money back."

Low risk, high reward

At $4.4 billion, the cost of buying AOL is practically chump change for Verizon, which reported about $127.1 billion in sales last year. AT&T, in contrast, will pay $49 billion to buy DirecTV.

To put Verizon's costs in perspective: It spent $10.4 billion earlier this year to buy spectrum licenses in an FCC wireless auction. And it's likely to spend as much or more in an upcoming auction scheduled for next year.

"They bought it for pocket change and they're paying cash for it," said Gartner's Menezes. "But if they can leverage the AOL digital advertising platform, the upside could be huge."