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Verizon is actually paying through the nose for AOL

Last year, when Comcast announced its proposed deal to buy Time Warner Cable and AT&T announced that it was buying DirecTV, Verizon was mum. A big acquisition was not part of Verizon’s strategy, said chief executive Lowell McAdam.

Even earlier this year, after news of a potential AOL deal surfaced in January, McAdam said, once again, that a deal was not going to happen. He said the only hook-ups the giant telecom is likely to do were partnerships, not acquisitions.

So much for that.

On Tuesday, Verizon (VZ) announced that it would buy Internet forefather-turned-mobile-ad-play AOL (AOL) for $4.4 billion. Why would Verizon be doing a deal now? With the Comcast deal off, Verizon’s go-it-alone strategy seems to be validated. And there are lots of reasons CEOs are wise to avoid M&A transactions. AOL’s own merger with Time Warner is exhibit No. 1 in why executives should resist the urge to merge.

But shares of Verizon have basically been flat for the past year, stuck at around $50. The company has said that it has a video strategy to deal with cable cord-cutters, but Wall Street hasn’t bought into the story. So, Verizon is likely doing a deal because buying always seems easier than building yourself or, just as likely, to prove to Wall Street that it is serious about being more than just a cable, Internet and phone service provider. Neither is a great reason for a deal.

In announcing the purchase, Verizon tried to paint the acquisition not as a change in strategy. McAdam said in a statement that the AOL deal was just an extension of the investment the company was already making in “emerging technology,” which seems like an odd way to describe AOL. But McAdams said AOL had transformed itself again into an Internet pioneer, this time in advertising technology, and that AOL’s “advertising platform provides a key tool for us to develop future revenue streams.”

Verizon has done big deals before, but not for a while. Most recently, it purchased half of Verizon Wireless for $130 billion, a business it already owned 55% of and controlled.

Relative to the size of Verizon, the AOL deal is small. Verizon has a market cap of $200 billion, and basically earned what it is paying for AOL in the first three months of this year alone.

But the odd thing here for the recently acquisition-shy Verizon is not just that it is buying AOL, but what it’s paying for the company.

In all, AOL earned $126 million last year. That means Verizon is paying 35 times AOL’s income for the company. That seems like a rich multiple, even for an Internet pioneer. Google, for instance, trades at an earnings multiple of 25 times its last 12 months of earnings.

But that 35 times includes AOL’s membership business, which shrank last year and likely wouldn’t sell for much if it were on its own. The number of AOL subscribers dropped by 11% in 2014.

AOL doesn’t report its net income by business segment, but it does report something called Adjusted OIBDA, which is operating income before such non-cash accounting expenses as depreciation and amortization. AOL also ignores the costs of compensating it employees with stock options to calculate that figure, something the SEC doesn’t allow you to do when reporting your official profit. Anyway, through some number shifting, AOL says it had $507 million in adjusted operating income last year, or $381 million more than its actual income.

Last year, AOL’s membership business generated $792 million in sales, or about 31% of its total revenues. But those membership fees are incredibly profitable—a lot of those people are paying for dial-up service or an e-mail address. The result: all of AOL’s adjusted operating income and then some, 111%, comes from its membership business, $562 million last year. (AOL says it lost $127 million in OIBDA from corporate expenses, which is how it gets to the lower figure.)

AOL did get over $1 billion in revenue from its “platform” segment, which includes the fast growing advertising technology division that Verizon appears to be most interested in. And those revenues were up by nearly 38% last year. However, despite the fast growth, AOL generated just $4.4 million in adjusted operating income from its advertising technology and related businesses, for a pathetically small adjusted operating margin of 0.3%. AOL generated another $68 million from its so-called branded business, which includes Huffington Post, Tech Crunch, and some of AOL’s other Internet properties that may be up for sale as part of this deal.

That means Verizon is paying 1,000 times adjusted operating earnings, not actual real earnings remember, for the business it wants. It’s attached to a shrinking, cash-generating membership business that may make the deal palatable, but still far from cheap.

When you don’t go shopping too often, you tend to overpay.