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AOL Needs a Quick Push from Patch

Maybe “hyperlocal” just doesn’t cut it.

Britain’s Guardian Newspaper recently shut down its local news initiative, citing financial concerns. The announcement may not be good news for AOL (NYSE:AOL).

The struggling Internet company is betting big on what’s called hyperlocal – AOL’s Patch is a network of more than 800 sites designed for communities with a population between 15,000 and 75,000. The idea is to replicate a community square with online news-gathering. The business proposition is attractive: low-cost operations that makes entrepreneurs out of journalists and depend on heavy community involvement to make a success.

So, the model should be a win-win, right?

Not really. The problem is that the economics of local advertising are complex and largely unproven. Quite simply, no one is sure about what works in hyperlocal advertising — even though everyone wants to be a part of it.

According to research by Borrell Associates – a Virgina-based analyst firm – the online advertising market is expected to grow to $24 billion by 2015, an increase of almost 50%. Conventional wisdom says that local advertisers gravitate toward the most heavily trafficked websites. Patch is on good ground there: traffic on Patch grew by almost 80% to 3 million visitors last year, according to Comscore.

However, page impressions are only only part of the game. Sites such as Google (NASDAQ:GOOG) and Groupon have hampered the local advertising pitch by enticing advertisers away from news and entertainment to Google’s search and Groupon’s daily deals offerings.

The skewed nature of the competition becomes clear when you consider data from AOL’s latest earnings report: advertising revenue declined by 29% to $331.6 million during the last quarter of 2010. One could argue that recession was responsible for the dropoff, but that argument falls flat when you consider that Google’s advertising revenue increased by 23% to $2.8 billion during the same period.

Clearly, AOL needs to package the bump in page impressions with a significant value proposition to businesses. This dynamic isn’t lost on AOL shareholders, who have seen the stock fall 14% so far this year.

Then there are the operational costs for Patch, which are low but still significant. Much of it goes to pay salaries of people involved: a local editor backed by a chain of command that includes a regional editor, a coast editor, and a national editor. The business side has an advertising manager, sales person and marketing person for every four Patch towns. According to the company’s latest balance sheet, it has already sunk more than $40 million into the venture.

Barclays analyst Douglas Anmuth estimates that AOL might end up sinking about $120 million into the venture. That’s a pretty significant sum for a business which is yet unproven.

The good part is that, despite its slew of acquisitions, which includes the recent purchase of The Huffington Post for $315 million, the company is debt-free. However, given AOL’s rapidly declining subscriber base (and the accompanying shortfall in revenue), Patch will have to generate revenue quickly to justify its existence.

When AOL’s stock was listed on the NYSE in 2009, the company’s CEO, Tim Armstrong, said, “We’re realistic about tomorrow. We want investors to say ‘Show us the results.’”

Patch needs to show results now for AOL to survive.

Article printed from InvestorPlace Media,

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