When a company is in deep distress, its board of directors is willing to take big chances. Acknowledging that its legacy Internet access business would soon stop throwing off gobs of cash, AOL (NYSE: AOL) handed the reins to Tim Armstrong, a thirty-something Google (Nasdaq: GOOG) veteran. He pitched a radical vision to the board: amass a broad roster of experienced journalists, develop a wide range of segment-leading websites, and watch the ad dollars roll in.

That plan surely carries risk at a time when online ad rates continue to badly lag ad rates found in other forms of media. Indeed, the results of Armstrong’s turnaround plan have been unimpressive, but he’s sticking to his guns with a newly-announced acquisition of The Huffington Post. Armstrong is now approaching his two-year anniversary with AOL, and two years hence, the deal to acquire Huffington Post will be looked back as a make-or-break moment for the company. Let’s peer into the future to see how it will play out.

No choice
Doing nothing was not an option for AOL’s board. Sales had fallen 47% in the two years before Armstrong arrived, though they have fallen an additional 42% since then. That was never too great a problem as long as AOL generated very strong free cash flow (FCF), which remained very stable in the $700 to $800 million range from 2006 to 2009. That figure slumped below $500 million in 2010, and analysts think it may fall to $300 million by 2012.

It’s not Armstrong’s fault: all that FCF came from a wildly-profitable Internet access business as tech-wary consumers stood by the AOL brand. But as an unnamed company executive recently told The New Yorker magazine, “the dirty little secret is that 75% of people that subscribe to AOL’s dial-up service don’t need it.” Word must be getting out, because many of those legacy subscribers are finally cutting the cord and switching to traditional broadband Internet-access providers. AOL had 13.2 million dial-up subscribers in 2006, though if current trends persist, that figure will fall below two million by 2012.

As Armstrong works to re-invent the business, he’s found the road to be bumpy. Much of the sales staff has been turned over, and a number of key properties are said to be carrying far more overhead (in terms of journalists’ salaries) than the revenue they are generating, Thus far, Armstrong hasn’t shown much of a stomach when it comes to shrinking or eliminating unproductive websites. More importantly, the drop in dial-up subscribers directly impacts the ad revenue that Armstrong is hoping to build. Advertising revenue has fallen from $2.2 billion in 2007, the year before Armstrong arrived, to just $1.3 billion in 2010.

To his credit, Armstrong has also aggressively taken a huge swing at AOL’s expense structure. Headcount has fallen from 9,900 to 4,500 in just two years. Operating costs have fallen at a 30% yearly pace, and a series of asset sales have pumped up the balance sheet. AOL had around $6 a share, or $802 million, in cash at the end of 2010.  

Part of that money is going toward Patch.com, a risky new venture that aims to have local web sites covering 1,000 towns and cities by the end of this year. On the plus side, locally-focused sites could become the new “town newspaper,” hosting a wide range of event listings, local news and classified ads. From a targeted marketing perspective, advertisers rarely have a chance to capture impressions at such a granular level. On the downside, this effort has been tried before — by AOL and others — without much success.

Armstrong is also taking a bold and risky gambit with a new ad program called Devil. The company has built an impressive platform that will serve as a one-stop shop for all advertisers, creating a uniform approach to the delivery of traditional ads, video and other content streams. He’s betting that advertisers will like the simplified approach, but many appear to be balking at the relatively high price points being charged to work on the Devil platform. Early results for Devil have been below plan.

Huffington Post to the rescue?
Will AOL’s just-announced $315 million acquisition of the Huffington Post (HuffPo) finally be the game-changer Armstrong has been looking for? The deal certainly brings rewards and risks. On the plus side, HuffPo, which had $30 million in revenue last year and expects to have $50 million this year, has become a proven leader in the online news field, which should help polish AOL’s efforts with its sites such as Engadget, TechCrunch, MovieFone, and others.

On the downside, HuffPo’s success has come on the back of unpaid volunteer contributors that wanted to be a part of a buzz-worthy hot new media property. (There’s a growing adage that journalists are underemployed and are willing to work for far less than before — or nothing. Truth is, that only works until the money runs out and many seek out other professions.) AOL will be hard-pressed to retain HuffPo’s talent unless it starts paying them real money.

HuffPo expects to generate $10 million in EBITDA in 2011, implying a very high purchase price at 30 times EBITDA. The HuffPo deal also saps roughly half of AOL’s cash balance.

Throw up a wall?
Now that AOL is on the cusp of generating a wide array of daily content, will it be tempted to throw up a wall and force readers to pay for access? I recently wrote that I’m dubious of that strategy for the New York Times Co. (NYSE: NYT), in part on concerns that it will reduce the number of visitors that Times advertisers crave. AOL would face a similar conundrum.

What’s it worth?
The real aim of the HuffPo deal is to turn AOL.com into a media portal. The world is changing and news media titans such as Newsweek and CBS News no longer carry the torch-bearing roles they once did. But do web surfers really stick by one portal for all of their content? Surely not. I read several AOL properties daily, along with a dozen other non-AOL sites that appeal to me. At the end of the day, it’s hard to see how the HuffPo deal changes the game for AOL, which will still have lots of content and still be hard-pressed to monetize that content.

And in a few short quarters, investors will realize that the company’s negative trajectory remains on pace. Lucrative dial-up Internet access subscribers will continue to flee, AOL will still be operating a number of its sites at a loss, the company’s FCF will continue to shrink, and the board’s patience with Armstrong will be stretched.

Action to Take –> If I’m right about AOL, you wouldn’t want to hold this stock. In fact, investors were underwhelmed by the HuffPo deal, pushing AOL down 2% to $21.50 in Monday trading. As the impact of the deal is further digested, keep an eye on the $20 support line. The stock has been making lower highs over the course of 2010, and if it pushes trough the $20 mark, I think the next move is to $15, which  in my view is the fundamental fair value.

The value of the dial-up business is fast-shrinking, and a decision to shut it down completely may happen in the next 12-18 months. The rest of the business, currently valued at $2.2 billion, seems worth closer to $1.5 billion when you consider that it has zero organic growth. Perhaps Armstrong’s turnaround plan is simply taking a very long time to take shape. More likely, it’s the right strategy for the wrong era.

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