FORTUNE — It was supposed to be a savior. AOL’s hyperlocal news venture Patch was created to fill the void left by the death of local newspapers around the country. Finding a dearth of online news in his Riverside, Connecticut hometown, Tim Armstrong co-founded Patch in 2007. Embedded editors would file local news and maintain neighborhood activity calendars; the local ad market was largely untapped, or so went the thinking. When Armstrong took the helm of AOL in 2009, the company acquired Patch for an estimated $7 million, making it a cornerstone of its transformation into an online media firm.
Now, the savior of local news may need saving. Patch’s progress has been anything but smooth, plagued by questions of profitability, high-level departures, budget strains and speculation of layoffs. Three years into the struggling AOL’s (AOL) much-watched turnaround, the question is will Patch’s financials ever turn in Armstrong’s favor?
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The math around Patch has always been tricky. In two years, it rapidly expanded to 863 sites, from Agoura Hills, California to Woonsocket, Rhode Island. Content is supplied by 1,000 professional journalists and some 14,000 bloggers. AOL has poured $160 million into the venture, despite paltry revenues. In 2011, it made just $20 million from Patch. “Basically, there [were] two ways to do it: get the product perfect in one market or go for a land grab approach,” explains a former AOL executive directly involved in the company’s strategy. This executive, who declined to be identified, says management opted for the latter, spending lavishly to expand and hire staff. “They went all in before they perfected the product and, in retrospect, that wasn’t ideal.”
The gulf between how much AOL has spent and made on Patch alarmed investors, including activist fund Starboard Value LP, which publicly berated management last December in a widely circulated letter. On an earnings call earlier this month, Armstrong dismissed the criticism, saying “some” Patch sites were profitable last year. That vague admission helped send shares up more than 13% that morning. But according to another former AOL employee with close knowledge of the business, just 12 of the 863 Patch sites were actually profitable during that time. “I think Patch is basically shitting the bed at this point,” says the person. Breaking even would require ten times last year’s revenues. “The current model is not going to work and fixing [it] with all those employees is hard.”
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AOL strongly disagrees with this view. “We’re not losing money — we’re investing. We’re not struggling. And we’re not a turnaround,” says Warren Webster, president of Patch. Webster notes that Patch attracts some 10 million unique visitors or about 11,587 readers for every individual site. Patch traffic, he adds, more than tripled in 2011. Revenues for 2012, it claims, are already 50% of what the company made in 2011. Small figures, perhaps, but indicative of progress the company claims.
Overall, AOL has been making progress. Fourth quarter earnings generally beat analysts’ estimates, leading many to conclude Armstrong’s turnaround is in fact taking hold. AOL earned 23 cents a share for the fourth quarter on revenue of $576.8 million, compared to 60 cents per share on $596 million in the same quarter a year ago. The company grew global ad revenue 10%, its third consecutive quarter of year-over-year growth, helping to stem overall revenue declines. The hitch? Uncertainty over Patch. Many analysts from the likes of Wells Fargo (WFC), Atlantic Equities, Jefferies (JEF) and Needham & Company noted concerns about the division as a drag on AOL’s future.
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The key to Patch’s success now may be finding ways to make money from the sites aside from online advertising, something which its recently hired Chief Content Officer, Rachel Fishman Fedderson, will have to deal with. (Some Patch sites now feature up to four ads on the top of their pages.) Patch could, for example, explore new revenue streams in commerce or listings. Whatever it does, it will need to in the next year. Not only is Armstrong’s dream of a thriving hyperlocal news hub at stake, more than 1,000 jobs are too. “I don’t know for sure if Patch will pay off,” admits Saul Hansell, former Programming Director for AOL’s Seed.com and one of Armstrong’s first prominent journalistic hires. “But now that they’ve built it, as a shareholder, I want them to keep it going for a few more years at least to see if they can capitalize on its enormous potential.”
Correction: An earlier version of this story mistakenly reported that each Patch site has 1,159 readers. That figure should be 11,587. Fortune regrets the error.
