AOL (AOL) 10-Q 2012 Q2 Quarterly report

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-Q

(Mark One)

x QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the quarterly period ended June 30, 2012

OR

¨ TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the transition period from              to             

Commission File Number 001-34419

AOL INC.

(Exact name of registrant as specified in its charter)

Delaware	20-4268793
(State or other jurisdiction of incorporation or organization)	(I.R.S. Employer Identification No.)
770 Broadway New York, NY	10003
(Address of principal executive offices)	(Zip Code)

Registrant’s telephone number, including area code: 212-652-6400

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.    Yes  x    No  ¨

Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).    Yes  x    No  ¨

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See the definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act.

Large accelerated filer  x	Accelerated filer  ¨
Non-accelerated filer  ¨	Smaller reporting company  ¨
(Do not check if a smaller reporting company)

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).    Yes  ¨    No  x

As of July 27, 2012, the number of shares of the Registrant’s common stock, par value $0.01 per share, outstanding was 93,973,079.

AOL INC.

TABLE OF CONTENTS

			Page     Number
PART I. FINANCIAL INFORMATION
		Cautionary Statement Concerning Forward-Looking Statements		1
	Item 2.	Management’s Discussion and Analysis of Financial Condition and Results of Operations		2
	Item 3.	Quantitative and Qualitative Disclosures About Market Risk		20
	Item 4.	Controls and Procedures		21
	Item 1.	Financial Statements		22
PART II. OTHER INFORMATION
	Item 1.	Legal Proceedings		35
	Item 1A.	Risk Factors		36
	Item 2.	Unregistered Sales of Equity Securities and Use of Proceeds		36
	Item 6.	Exhibits		36
Signatures				37
Exhibit Index				38

AOL INC.

INDEX TO CONSOLIDATED FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA

	Page     Number
Consolidated Statements of Comprehensive Income for the Three and Six Months Ended June  30, 2012 and 2011		22
Consolidated Balance Sheets as of June 30, 2012 and December 31, 2011		23
Consolidated Statements of Cash Flows for the Six Months Ended June 30, 2012 and 2011		24
Consolidated Statements of Equity for the Six Months Ended June 30, 2012 and 2011		25
Note 1: Description of Business, Basis of Presentation and Summary of Significant Accounting Policies		26
Note 2: Income (Loss) Per Common Share		28
Note 3: Goodwill		28
Note 4: Business Acquisitions, Dispositions and Other Significant Transactions		29
Note 5: Income Taxes		30
Note 6: Stockholders’ Equity		31
Note 7: Equity-Based Compensation		32
Note 8: Restructuring Costs		33
Note 9: Commitments and Contingencies		34
Note 10: Segment Information		34

CAUTIONARY STATEMENT CONCERNING FORWARD-LOOKING STATEMENTS

This Quarterly Report on Form 10-Q (“Quarterly Report”) contains certain “forward-looking statements” within the meaning of the Private Securities Litigation Reform Act of 1995 regarding business strategies, market potential, future financial and operational performance and other matters. Words such as “anticipates,” “estimates,” “expects,” “projects,” “forecasts,” “intends,” “plans,” “will,” “believes” and words and terms of similar substance used in connection with any discussion of future operating or financial performance identify forward-looking statements. These forward-looking statements are based on management’s current expectations and beliefs about future events. As with any projection or forecast, they are inherently susceptible to uncertainty and changes in circumstances. Except as required by law, we are under no obligation to, and expressly disclaim any obligation to, update or alter any forward-looking statements whether as a result of such changes, new information, subsequent events or otherwise.

Various factors could adversely affect our operations, business or financial results in the future and cause our actual results to differ materially from those contained in the forward-looking statements, including those factors discussed in detail in “Item 1A—Risk Factors” in our Annual Report on Form 10-K for the year ended December 31, 2011 (“Annual Report”). In addition, we operate a web services company in a highly competitive, rapidly changing and consumer- and technology-driven industry. This industry is affected by government regulation, economic, strategic, political and social conditions, consumer response to new and existing products and services, technological developments and, particularly in view of new technologies, the continued ability to protect intellectual property rights. Our actual results could differ materially from management’s expectations because of changes in such factors.

Achieving our business and financial objectives, including growth in operations and maintenance of a strong balance sheet and liquidity position, could be adversely affected by the factors discussed or referenced in “Item 1A—Risk Factors” in our Annual Report as well as, among other things:

• changes in our plans, strategies and intentions;

• continual decline in market valuations associated with our cash flows and revenues;

• the impact of significant acquisitions, dispositions and other similar transactions;

• our ability to attract and retain key employees;

• any negative unintended consequences of cost reductions, restructuring actions or similar efforts, including with respect to any associated savings, charges or other amounts;

• market adoption of new products and services;

• the failure to meet earnings expectations;

• asset impairments;

• decreased liquidity in the capital markets;

• our ability to access the capital markets for debt securities or bank financings; and

• the impact of “cyber warfare” or terrorist acts and hostilities.

References in this Quarterly Report to “we,” “us,” the “Company,” and “AOL” refer to AOL Inc., a Delaware corporation.

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AOL INC.

PART I - ITEM 2. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

You should read the following discussion of our results of operations and financial condition together with our consolidated financial statements and the notes thereto included elsewhere in this Quarterly Report as well as the discussion in the “Item 1—Business” section of our Annual Report. This discussion contains forward-looking statements that involve risks and uncertainties. The forward-looking statements are not historical facts, but rather are based on current expectations, estimates, assumptions and projections about our industry, business and future financial results. Our actual results could differ materially from the results contemplated by these forward-looking statements due to a number of factors, including those discussed in “Item 1A—Risk Factors” in our Annual Report and “Cautionary Statement Concerning Forward-Looking Statements” herein.

Introduction

Management’s discussion and analysis of financial condition and results of operations (“MD&A”) is a supplement to the accompanying consolidated financial statements and provides additional information on our business, recent developments, results of operations, liquidity and capital resources and critical accounting policies. MD&A is organized as follows:

• Overview. This section provides a general description of our business and outlook for 2012, as well as recent developments we believe are important in understanding our results of operations and financial condition or in understanding anticipated future trends.

• Results of operations. This section provides an analysis of our results of operations for the three and six months ended June 30, 2012 and 2011.

• Liquidity and capital resources. This section provides a discussion of our current financial condition and an analysis of our cash flows for the six months ended June 30, 2012 and 2011. This section also provides an update to the discussion in our Annual Report of our customer credit risk and includes a discussion of the amount of financial capacity available to fund our future commitments and ongoing operating activities.

• Critical accounting policies. This section identifies those accounting policies that are considered important to our results of operations and financial condition and require significant judgment and estimates on the part of management.

Overview

Our Business

We are a leading global web services company with a suite of compelling brands and offerings and a substantial worldwide audience. Our business spans online content, products and services that we offer to consumers, publishers and advertisers. We are focused on attracting and engaging internet consumers and providing valuable online advertising services. We market our offerings to advertisers on both AOL Properties and the Third Party Network under the brand “AOL Advertising.” Through the Advertising.com Group, we provide third party publishers with premium products and services intended to make their websites attractive to brand advertisers, such as video and custom content production, in addition to offering ad serving and sales of third party advertising inventory. Our AOL-brand access subscription service, which we offer consumers in the United States for a monthly fee, is a valuable distribution channel for AOL Properties.

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On June 29, 2012, we announced a plan to form operating units in conjunction with a planned change in management structure. As part of that change, our Chief Financial Officer will be taking on the role of Chief Operating Officer, but will continue to also serve as our Chief Financial Officer until a new Chief Financial Officer is hired. We currently plan to form the operating units to organize our business into three main areas; AOL Membership, Brands (including Patch) and Advertising.com. This new operating structure will allow the Company to focus on profitability, coordinated business execution, and resource allocation across its portfolio of brands and services. We have initiated the process to prepare detailed profitability information for each of these areas of our business, and expect to complete that process by the end of the year. As of June 30, 2012, we continue to have one operating and reportable segment.

AOL Properties include our owned and operated content, products and services in the Huffington Post Media Group (“HPMG”), AOL Services and Local and Mapping strategy areas. AOL Properties also include co-branded websites owned or operated by third parties for which certain criteria have been met, including that the internet traffic has been assigned to us. We generate advertising revenues from AOL Properties through the sale of display advertising and search and contextual advertising. Display advertising revenue is generated by the display of graphical advertisements and other performance-based advertising. We offer advertisers marketing and promotional opportunities to purchase specific placements of advertising directly on AOL Properties (i.e., in particular locations and on specific dates). In addition, we offer advertisers the opportunity to bid on unreserved advertising inventory on AOL Properties utilizing our proprietary scheduling, optimization and delivery technology. We collectively refer to revenue associated with these offerings as premium display advertising revenue. Finally, advertising inventory on AOL Properties not sold directly to advertisers, as described above, may be included for sale to advertisers with inventory purchased from third-party publishers in the Third Party Network. Search and contextual advertising revenue is generated when a consumer clicks on a text-based advertisement on AOL Properties. These text-based advertisements are either generated from a consumer-initiated search query or placed on sites targeted by advertisers based on the content of the websites.

We also generate advertising revenues through the sale of advertising on third party websites, which we collectively refer to as the Third Party Network. Our advertising offerings on the Third Party Network consist primarily of the sale of display advertising and also include search and contextual advertising. In order to generate advertising revenues on the Third Party Network, we have historically had to incur higher traffic acquisition costs (“TAC”) as compared to advertising on AOL Properties.

Growth of our advertising revenues depends on our ability to attract consumers and increase engagement on AOL Properties by offering compelling content, products and services, as well as on our ability to provide effective advertising solutions and optimize our inventory monetization. In order to attract consumers and generate increased engagement, we have developed and acquired, and intend to continue to develop and potentially acquire, content, products and services designed to meet these goals. Our plans include the development of a number of platforms that are designed to facilitate the production, aggregation, distribution and consumption of national and local content. Additionally, through the creation of the HPMG, we have accelerated our strategy to deliver a scaled and differentiated array of premium news, analysis, commentary, entertainment and community engagement.

Historically, our primary subscription service has been our subscription access service. To supplement our subscription access service, we are marketing new products and services that are either third party or AOL-developed products. We earn performance-based fees in relation to marketing third party products and services. We offer these products to our current and former access subscribers as well as other internet consumers.

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Key indicators to understanding our operating results include:

• Growth of advertising revenues;

• Unique visitors to AOL Properties;

• Monthly average churn and average paid tenure of our AOL-brand access subscribers;

• Our investment in the local online market, which we believe is a potential growth area; and

• Our ability to manage our operating cost structure.

Trends, Challenges and Uncertainties Impacting Our Business

The web services industry is highly competitive and rapidly changing. Trends, challenges and uncertainties that may have a significant impact on our business, our opportunities and our ability to execute our strategy include the following:

• Advertising, commerce and information continue to migrate to the internet and away from traditional media outlets. We believe this continuing trend will create strategic growth opportunities for us to attract new consumers and develop new and effective advertising solutions. Additionally, the amount of content that is available online continues to expand. We believe our strategy is aligned with this rapid expansion as we aim to create a global content brand network while providing our consumers with an array of news, analysis, commentary, entertainment and community engagement. We offer a variety of sites that we expect to continue to drive consumer engagement, focusing on target audiences such as women, local and influencers. We continue to expand our distribution of our content, products and services on multiple platforms and digital devices (e.g., PCs, laptops, mobile phones and tablets).

• We believe that there is a significant strategic growth opportunity in providing local content, platforms and services covering geographic locations ranging from neighborhoods to major metropolitan areas. Patch is our community-specific news and information platform dedicated to providing comprehensive and trusted local coverage for individual towns and communities. We have been investing in the development of this platform as well as developing and offering compelling local content and growing user engagement within Patch towns. We have increased our focus on local, regional and national advertising and commerce opportunities as we continue the next phase of our development of Patch.

• The method of internet access continues to shift away from dial-up access and this trend has contributed to the decline in our subscription revenues. We have evolved our offerings of online products and services to provide significant value to our subscribers and other consumers. Our offerings to consumers include computer tools, maintenance and warranty services, online technical support, anti-virus software, identity theft protection, online and social media privacy and reputation monitoring services. We expect that these products will allow us to continue to grow new subscription services and expand our customer base. As the number of subscribers has declined, our remaining subscriber base has become longer tenured. We believe that subscription revenues and subscriber churn will continue to moderate in the foreseeable future as our tenured base matures and the value of the additional products and services offered to subscribers increases.

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• We believe there is a growing advertiser demand for innovation in online advertising formats to be more conducive to product branding. To address this opportunity, we are focusing on premium formats and video to create an enhanced experience for consumers and advertisers. We are increasing our traffic on premium news, analysis, commentary, entertainment and community engagement through HPMG. We are also increasing video streams and reach through video platforms and networks offered by 5 Minutes Ltd. (“5Min”) and goviral ApS (“goviral”) and improving premium format advertising offerings through Pictela, Inc.

Recent Developments

Patent Portfolio Sale and License

On June 15, 2012, we sold approximately 800 of our patents and their related patent applications (the “Sold Patents”) to Microsoft Corporation, a Washington corporation (“Microsoft”), and granted Microsoft a non-exclusive license to our retained patent portfolio, for aggregate proceeds of $1,056 million in cash (excluding transaction costs). Of this amount, $960 million is associated with the disposition of the Sold Patents and $96 million is associated with non-exclusive license fees. The sale transaction was structured as a purchase of all of the outstanding shares of a wholly owned non-operating subsidiary and the direct sale of certain other patents not held by the subsidiary.

The disposed assets had a carrying value of $4.0 million on the Company’s balance sheet and accordingly, the Company recorded a gain on the disposition of the Sold Patents of $945.8 million (which represents the consideration allocated to the sale less the carrying value of the disposed assets and transaction costs that were contingent on closing). With respect to the licensing portion of the transaction, the Company recognized income from licensing its retained patent portfolio of $96 million for the three months ended June 30, 2012. Based on the anticipated utilization of tax losses generated by the sale of the non-operating subsidiary and existing deferred tax assets, we do not expect this transaction to result in material cash taxes. For additional information on this transaction, see “Note 4” in our accompanying consolidated financial statements.

Stock Repurchase Program

On August 10, 2011, our Board of Directors approved a stock repurchase program, which authorizes us to repurchase up to $250.0 million of our outstanding shares of common stock from time to time through August 2012. Repurchases are subject to market conditions, share price and other factors. Repurchases have been and will be made in accordance with applicable securities laws in the open market or in private transactions and may include derivative transactions. Under this program, as of June 30, 2012, we repurchased a total of 14.8 million shares at a weighted-average price of $14.11 per share (approximately $209 million).

Dutch Auction Tender Offer

On June 28, 2012, we announced the first step in the multi-stage process of returning 100% of the patent transaction proceeds to shareholders through a $400.0 million modified Dutch auction tender offer. The $400.0 million aggregate purchase price of shares of common stock sought in the tender offer includes the approximately $40.0 million remaining from the initial $250.0 million stock repurchase authorized in August of 2011. The tender offer began on the date of the announcement, June 28, 2012, and will expire at 5:00PM ET at August 2, 2012 unless extended, amended or terminated earlier. Through the Dutch tender offer, AOL’s shareholders will have the opportunity to tender some or all of their shares at a price within the range of $27.00 to $30.00 per share.

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Key Metrics

Audience Metrics

We utilize unique visitor numbers to evaluate the performance of AOL Properties. In addition, we utilize unique visitor numbers to evaluate the reach of our total advertising network, which includes both AOL Properties and the Third Party Network. Unique visitor numbers provide an indication of our consumer reach. Although our consumer reach does not correlate directly to advertising revenue, we believe that our ability to broadly reach diverse demographic and geographic audiences is attractive to brand advertisers seeking to promote their brands to a variety of consumers without having to partner with multiple content providers. AOL’s unique visitor numbers also include unique visitors attributable to co-branded websites owned by third parties for which certain criteria have been met, including that the internet traffic has been assigned to us through a traffic assignment letter. For the three months ended June 30, 2012, approximately 7.1% of our unique visitors to AOL Properties were attributable to co-branded websites owned by third parties where the internet traffic was assigned to us, compared to approximately 6.3% for the three months ended June 30, 2011.

The source for our unique visitor information is a third party (comScore Media Metrix, or “Media Metrix”). While we are familiar with the general methodologies and processes that Media Metrix uses in estimating unique visitors, we have not performed independent testing or validation of Media Metrix’s data collection systems or proprietary statistical models, and therefore we can provide no assurance as to the accuracy of the information that Media Metrix provides.

The following table presents our unique visitor metrics for the periods presented (in millions):

	Three Months Ended June 30,				Six Months Ended June 30,
	2012		2011		2012		2011
Domestic average monthly unique visitors to AOL Properties		112		113		110		113
Domestic average monthly unique visitors to AOL Advertising Network		186		183		186		181

Subscriber Access Metrics

The primary metrics we monitor for our subscription access service are monthly average churn and average paid tenure. Monthly average churn represents on average the percentage of AOL-brand access subscribers that terminate or cancel our services each month, factoring in new and reactivated subscribers. The domestic AOL-brand access subscriber monthly average churn was 1.7% and 2.2% for the three months ended June 30, 2012 and 2011, respectively. Average paid tenure represents the average period of time subscribers have paid for domestic AOL-brand internet access. The average paid tenure of the remaining domestic AOL-brand access subscribers has been increasing, and was approximately 11.7 years and 10.5 years for the three months ended June 30, 2012 and 2011, respectively.

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Results of Operations

Revenues

The following table presents our revenues, by revenue type, for the periods presented (in millions):

	Three Months Ended June 30,						Six Months Ended June 30,
	2012		2011		% Change		2012		2011		% Change
Revenues:
Advertising	$	337.8	$	319.0		6 %	$	667.9	$	632.7		6 %
Subscription		175.5		201.3		(13)%		357.6		416.7		(14)%
Other		17.8		21.9		(19)%		35.0		44.2		(21)%
Total revenues	$	531.1	$	542.2		(2)%	$	1,060.5	$	1,093.6		(3)%

The following table presents our revenues, by revenue type, as a percentage of total revenues for the periods presented:

	Three Months Ended June 30,				Six Months Ended June 30,
	2012		2011		2012		2011
Revenues:
Advertising		64%		59%		63%		58%
Subscription		33		37		34		38
Other		3		4		3		4
Total revenues		100%		100%		100%		100%

Advertising Revenues

Advertising revenues are generated on AOL Properties through display advertising and search and contextual advertising, as described in “Overview – Our Business” herein. Agreements for advertising on AOL Properties typically take the form of impression-based contracts in which we provide impressions in exchange for a fixed fee (generally stated as cost-per-thousand impressions), time-based contracts in which we provide a minimum number of impressions over a specified time period for a fixed fee or performance-based contracts in which performance is measured in terms of either “click-throughs” when a user clicks on a company’s advertisement or other user actions such as product/customer registrations, survey participation, sales leads or product purchases. In addition, agreements with advertisers can include other advertising-related elements such as content sponsorships, exclusivities or advertising effectiveness research.

In addition to advertising revenues generated on AOL Properties, we also generate revenues from our advertising offerings on the Third Party Network. To generate revenues on the Third Party Network, we purchase advertising inventory from publishers (both large and small) in the Third Party Network using proprietary optimization, targeting and delivery technology to best match advertisers with available advertising inventory. Advertising arrangements for the sale of Third Party Network inventory typically take the form of impression-based contracts or performance-based contracts.

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Advertising revenues on AOL Properties and the Third Party Network for the three and six months ended June 30, 2012 and 2011 are as follows (in millions):

	Three Months Ended June 30,						Six Months Ended June 30,
	2012		2011		% Change		2012		2011		% Change
AOL Properties:
Display	$	139.9	$	137.6		2 %	$	270.2	$	266.1		2 %
Search and Contextual		86.5		87.8		(1)%		176.1		183.6		(4)%
Total AOL Properties		226.4		225.4		0 %		446.3		449.7		(1)%
Third Party Network		111.4		93.6		19 %		221.6		183.0		21 %
Total advertising revenues	$	337.8	$	319.0		6 %	$	667.9	$	632.7		6 %

Advertising revenues increased $18.8 million and $35.2 million for the three and six months ended June 30, 2012, respectively, as compared to the same periods in 2011, primarily reflecting an increase in Third Party Network revenue and global display revenue, partially offset by declines in search and contextual revenue. The increase in Third Party Network revenue of $17.8 million and $38.6 million for the three and six months ended June 30, 2012, respectively, relates primarily to an increase in publishers on the network and increased sales of higher margin premium packages and products. In addition, Third Party Network revenue increased by $7.5 million and $13.9 million, for the three and six months ended June 30, 2012, respectively, as a result of the consolidation of Ad.com Japan beginning in the first quarter of 2012. The increase in display revenue of $2.3 million and $4.1 million for the three and six months ended June 30, 2012, respectively, primarily relates to growth in reserved inventory pricing, Patch revenue and international revenue, primarily in the UK, partially offset by a decline in reserved impressions sold. Search and contextual revenue declined $1.3 million and $7.5 million for the three and six months ended June 30, 2012, respectively, as compared to the same periods in 2011, mainly due to a decline in AOL-brand access subscribers, a decline in queries on cobranded portals and fewer international queries. These declines in search and contextual include offsetting impacts related to growth in search revenue on AOL.com of $7.6 million and $13.9 million, respectively, for the three and six months ended June 30, 2012, respectively, as compared to the same periods in 2011.

Revenues Associated with Google

For all periods presented in this Quarterly Report, we have had a contractual relationship with Google Inc. (“Google”) whereby we generate revenues through paid text-based search and contextual advertising on AOL Properties provided by Google, which represent a significant percentage of the advertising revenues generated by AOL Properties. For the three and six months ended June 30, 2012, the revenues associated with the Google relationship (substantially all of which were search and contextual revenues generated on AOL Properties) were $80.5 million and $165.0 million, respectively, as compared to $83.1 million and $171.3 million for the three and six months ended June 30, 2011, respectively.

Subscription Revenues

The number of domestic AOL-brand access subscribers was 3.0 million and 3.4 million at June 30, 2012 and 2011, respectively. Domestic average monthly revenue per AOL-brand access subscriber (“ARPU”) was $17.92 and $17.90 for the three and six months ended June 30, 2012, respectively, compared to $17.53 and $17.75 for the three and six months ended June 30, 2011, respectively. We include in our subscriber numbers

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individuals, households and entities that have provided billing information and completed the registration process sufficiently to allow for an initial log-on to the AOL access service. Individuals who have registered for our free offerings, including subscribers who have migrated from paid subscription plans, are not included in the AOL-brand access subscriber numbers presented above. Subscribers to our subscription access service contribute to our ability to generate advertising revenues.

Subscription revenues declined 13% and 14% for the three and six months ended June 30, 2012, respectively, as compared to the same periods in 2011. The decline was due to an approximate 12% decrease in the number of domestic AOL-brand access subscribers between June 30, 2011 and June 30, 2012. Subscription revenue for the three and six months ended June 30, 2012 as compared to the three and six months ended June 30, 2011 also includes a favorable impact related to the simplified pricing structure initiated in late 2011.

Other Revenues

Other revenues consist primarily of licensing revenues from licensing our proprietary ad serving technology to third parties through our subsidiary, ADTECH, licensing revenues from third-party customers of MapQuest’s business-to-business services and fees associated with our mobile e-mail and instant messaging functionality from mobile carriers. In addition, other revenue also includes revenue from ticket sales related to technology events hosted by TechCrunch and production fees for videos produced by StudioNow.

Other revenues decreased 19% and 21% for the three and six months ended June 30, 2012, respectively, as compared to the same periods in 2011, due primarily to a decrease in revenues from our mobile messaging services as mobile carriers continue to move away from paying on a per message basis and a decline in third party web hosting revenues. In addition, the decline for the six months ended June 30, 2012 includes a decline in transition services revenue partially offset by an increase in StudioNow revenues and ADTECH licensing revenues.

Geographical Concentration of Revenues

For the periods presented herein, a significant majority of our revenues have been generated in the United States. The majority of the non-United States revenues for these periods were generated by our European operations (primarily in the United Kingdom). We expect the significant majority of our revenues to continue to be generated in the United States for the foreseeable future. See “Note 1” in our accompanying consolidated financial statements for further discussion of our geographical concentrations.

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Operating Costs and Expenses

The following table presents our operating costs and expenses for the periods presented (in millions):

	Three Months Ended June 30,						Six Months Ended June 30,
	2012		2011		% Change		2012		2011		% Change
Costs of revenues	$	396.2	$	403.4		(2)%	$	780.8	$	792.3		(1)%
General and administrative		107.8		117.3		(8)%		204.0		238.0		(14)%
Amortization of intangible assets		9.8		26.7		(63)%		19.6		50.9		(61)%
Restructuring costs		(0.1)		0.6		NM		7.3		28.4		(74)%

NM = not meaningful

The following table represents our operating costs and expenses as a percentage of revenues for the periods presented:

	Three Months Ended June 30,						Six Months Ended June 30,
	2012			2011			2012			2011
Operating costs and expenses:
Costs of revenues		75	%		74	%		74	%		72	%
General and administrative		20			22			18			21
Amortization of intangible assets		2			5			2			5
Restructuring costs		-			-			1			3
Operating costs and expenses		97	%		101	%		95	%		101	%

Costs of Revenues

The following categories of costs are generally included in costs of revenues: personnel and facilities costs, TAC, network-related costs, non-network depreciation and amortization and other costs of revenues. TAC consists of costs incurred through arrangements in which we acquire third-party online advertising inventory for resale and arrangements whereby partners distribute our free products or services or otherwise direct traffic to AOL Properties. TAC arrangements have a number of different economic structures, the most common of which are: payments based on a cost per thousand impressions or based on a percentage of the ultimate advertising revenues generated from the advertising inventory acquired for resale and payments for direct traffic delivered to AOL Properties priced on a per click basis (e.g., search engine marketing fees). These arrangements are primarily on a variable basis; however, the arrangements can also be on a fixed-fee basis, which often carry reciprocal performance guarantees by the counterparty, or a combination of fixed and variable.

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Costs of revenues for the three and six months ended June 30, 2012 and 2011 are as follows (in millions):

	Three Months Ended June 30,						Six Months Ended June 30,
	2012		2011		% Change		2012		2011		% Change
Costs of revenues:
Personnel costs	$	159.5	$	163.4		(2)%	$	321.6	$	321.9		(0)%
Facilities costs		13.2		15.6		(15)%		27.2		28.5		(5)%
TAC		82.4		74.3		11 %		163.2		145.7		12 %
Network-related costs		40.2		47.0		(14)%		81.0		95.4		(15)%
Non-network depreciation and amortization		16.2		18.1		(10)%		32.6		36.7		(11)%
Other costs of revenues		84.7		85.0		(0)%		155.2		164.1		(5)%
Total costs of revenues	$	396.2	$	403.4		(2)%	$	780.8	$	792.3		(1)%

Costs of revenues decreased for the three and six months ended June 30, 2012 as compared to the same period in 2011.

The decrease in personnel costs for the three and six months ended June 30, 2012 as compared to the same period in 2011 is primarily due to declines in retention compensation expense of $7.9 million and $11.0 million, respectively, related to our 2010 and 2011 acquisitions, partially offset by increases in headcount in strategic areas.

TAC increased for the three and six months ended June 30, 2012 as compared to the same periods in 2011, primarily due to the increase in Third Party Network advertising revenues, which resulted in higher variable revenue share payments to our publishing partners (including increases in TAC as a result of our consolidation of Ad.com Japan of $5.1 million and $9.3 million for the three and six months ended June 30, 2012, respectively).

The decrease in network-related costs is primarily due to the decommissioning of certain network equipment, which is due in part to the decline in the number of domestic AOL-brand access subscribers. Costs of revenues for the three and six months ended June 30, 2012 also included a decline in non-network depreciation and amortization primarily due to a decline in depreciable and amortizable assets.

Other costs of revenues decreased for the three and six months ended June 30, 2012 as compared to the same period in 2011 due to declines in internal content development costs of $4.4 million and $17.5 million, respectively, and a decrease in billing expenses of $1.0 million and $2.4 million, respectively, due to the decline in AOL brand-access subscribers. These declines were partially offset by increased costs of $1.9 million for the six months ended June 30, 2012 relating to the launch of paid services products, an increase in ad serving expense of $2.5 million and $4.5 million for the three and six months ended June 30, 2012, respectively, and an increase in sales tax expense of $7.6 million and $9.6 million for the three and six months ended June 30, 2012, respectively, relating to the Virginia sales tax settlement in the second quarter of 2012.

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PART I - ITEM 2. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND

RESULTS OF OPERATIONS

General and Administrative

General and administrative expenses decreased $9.5 million and $34.0 million for the three and six months ended June 30, 2012 as compared to the three and six months ended June 30, 2011. The decrease was due to a decline in personnel costs of $15.6 million and $29.7 million, respectively, including the impact of reduced corporate headcount and reduced stock compensation expense resulting from vesting of certain stock awards in December 2011, a decline in marketing expenses of $4.4 million and $6.9 million, respectively, and a decline in consulting costs of $0.3 million and $5.8 million, respectively, partially offset by an increase in legal expenses of $4.0 million and $2.8 million, respectively.

Included in general and administrative expense for the three and six months ended June 30, 2012 are costs related to the proxy contest of $8.8 million and $10.6 million, respectively and costs related to the patent transaction of $5.6 million and $6.4 million, respectively.

Amortization of Intangible Assets

Amortization of intangible assets results primarily from acquired intangible assets including acquired technology, customer relationships and trade names. Amortization of intangible assets decreased $16.9 million and $31.3 million for the three and six months ended June 30, 2012 as compared to the same period in 2011, related to the impact of certain intangible assets becoming fully amortized.

Restructuring Costs

For the three months ended June 30, 2012, we recorded a reduction to expense of $0.1 million related primarily to changes in previous estimates of restructuring costs. For the six months ended June 30, 2012, we incurred $7.3 million of restructuring costs related to organizational changes made in an effort to improve our ability to execute our strategy. These restructuring costs were primarily related to involuntary terminations of employees.

We incurred $0.6 million and $28.4 million of restructuring costs for the three and six months ended June 30, 2011 related to our restructuring activities to better align our organizational structure and costs with our strategy. Restructuring costs for the six months ended June 30, 2011 includes costs incurred as a result of our acquisition of The Huffington Post and costs incurred as a result of the reassessment of our operations in India. The majority of these costs related to involuntary employee terminations.

Other Transactions Impacting Operating Income

The following table presents other transactions impacting operating income for the periods presented (in millions):

	Three Months Ended June 30,							Six Months Ended June 30,
	2012			2011		% Change		2012			2011		% Change
Income from licensing of intellectual property	$	(96.0	)		-		NM	$	(96.0	)	$	-		NM
(Gain) loss on disposal of assets, net		(945.8	)		-		NM		(945.8	)		1.6		NM

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Income from licensing of intellectual property of $96.0 million for the three and six months ended June 30, 2012 reflects the license of our retained patent portfolio to Microsoft in June 2012. The gain on disposal of assets, net of $945.8 million for the three and six months ended June 30, 2012 reflects the sale of the Sold Patents to Microsoft. See “Note 4” in our accompanying consolidated financial statements for additional information.

Operating Income (Loss)

Operating income was $1,059.2 million and $1,090.6 million for the three and six months ended June 30, 2012 as compared to operating loss of $5.8 million and $17.6 million for the three and six months ended June 30, 2011. The change from operating loss to operating income for the three and six months ended June 30, 2012 as compared to the same periods in 2011 was due to the gain on the disposition of the Sold Patents and income from licensing of intellectual property, declines in cost of revenues, general and administrative costs, amortization of intangible assets and restructuring costs, partially offset by the decline in revenues.

Other Income Statement Amounts

The following table presents our other income statement amounts for the periods presented (in millions):

	Three Months Ended June 30,						Six Months Ended June 30,
	2012		2011		% Change		2012		2011		% Change
Other income (loss), net	$	(1.1)	$	(1.7)		(35)%	$	7.3	$	(1.1)		NM
Income tax provision (benefit)		87.5		4.3		NM		106.3		(11.6)		NM

Other Income (Loss), Net

There were no significant changes in other income (loss), net for the three months ended June 30, 2012 as compared to the three months ended June 30, 2011. Other income, net was $7.3 million for the six months ended June 30, 2012 as compared to other loss, net of $1.1 million for the six months ended June 30, 2011. The increase for the six months ended June 30, 2012 as compared to the six months ended June 30, 2011 was due primarily to the $10.8 million gain related to the consolidation of Ad.com Japan recorded in the first quarter of 2012, partially offset by unfavorable foreign currency impacts of $1.8 million.

Income Tax Provision (Benefit)

We recorded pre-tax income from operations of $1,058.1 million and related income tax expense of $87.5 million, which resulted in an effective tax rate of 8.3% for the three months ended June 30, 2012, as compared to a negative effective tax rate of 57.3% for the three months ended June 30, 2011. The effective tax rate for the three months ended June 30, 2012 differed substantially from the statutory U.S. federal income tax rate of 35.0% primarily due to the tax impact of the patent transaction with Microsoft. The patent transaction consisted of two elements: first, the sale of patents and the stock of a subsidiary, and second, the licensing of our retained patent portfolio, resulting in pre-tax income of $1,041.8 million. No material cash taxes will be paid, due to existing net operating losses which offset substantially all of the ordinary income. However, for book purposes, this transaction resulted in income tax expense of $71.5 million. The tax expense relates primarily to ordinary income realized on the transaction, the majority of which is due to the licensing portion. In addition, the transaction created a significant capital loss due to the tax basis in the disposed subsidiary. We do not believe it is currently more likely than not that this capital loss will be realized, and accordingly, have recorded a full valuation allowance on the capital loss generated by the patent transaction. In addition to the impacts of the patent transaction on income tax expense, we also had foreign losses that did not produce a tax benefit.

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PART I - ITEM 2. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND

RESULTS OF OPERATIONS

We recorded income from operations before income taxes of $1,097.9 million and related income tax expense of $106.3 million, which resulted in an effective tax rate of 9.7% for the six months ended June 30, 2012, as compared to the effective tax rate of 62.0% for the six months ended June 30, 2011. The effective tax rate for the six months ended June 30, 2012 differed substantially from the statutory U.S. federal income tax rate of 35.0% primarily due to the tax impact of the patent transaction with Microsoft, described above. In addition to the impacts of the patent transaction on income tax expense, we also had foreign losses that did not produce a tax benefit. The effective tax rate for six months ended June 30, 2011 differed from the statutory U.S. federal income tax rate of 35.0% primarily due to $7.1 million of income tax benefit associated with a worthless stock deduction related to the sale of a subsidiary in the first quarter of 2011 and favorable adjustments of $8.0 million related to escrow disbursements from prior acquisitions for which we concluded a tax benefit could be recognized.

Adjusted OIBDA

We use Adjusted OIBDA as a supplemental measure of our performance. We define Adjusted OIBDA as operating income before depreciation and amortization excluding the impact of restructuring costs, non-cash equity-based compensation, gains and losses on all disposals of assets (including those recorded in costs of revenues) and non-cash asset impairments and write-offs. We consider Adjusted OIBDA to be a useful metric for management and investors to evaluate and compare the ongoing operating performance of our business on a consistent basis across reporting periods, as it eliminates the effect of non-cash items such as depreciation of tangible assets, amortization of intangible assets that were primarily recognized in business combinations, asset impairments and write-offs, as well as the effect of restructurings and gains and losses on asset sales, which we do not believe are indicative of our core operating performance. We exclude the impacts of equity-based compensation to allow us to be more closely aligned with the industry and analyst community. A limitation of this measure, however, is that it does not reflect the periodic costs of certain capitalized tangible and intangible assets used in generating revenues in our business or the current or future expected cash expenditures for restructuring costs. The Adjusted OIBDA measure also does not include equity-based compensation, which is and will remain a key element of our overall long-term compensation package. Moreover, the Adjusted OIBDA measures do not reflect gains and losses on asset sales or impairment charges and write-offs related to goodwill, intangible assets and fixed assets which impact our operating performance. We evaluate the investments in such tangible and intangible assets through other financial measures, such as capital expenditure budgets, investment spending levels and return on capital.

Adjusted OIBDA is a non-GAAP financial measure and may be different than similarly-titled non-GAAP financial measures used by other companies. The presentation of this financial information is not intended to be considered in isolation or as a substitute for the financial information prepared and presented in accordance with generally accepted accounting principles (“GAAP”).

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PART I - ITEM 2. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND

RESULTS OF OPERATIONS

The following table presents our reconciliation of Adjusted OIBDA to operating income (in millions):

	Three Months Ended June  30,							Six Months Ended June 30,
	2012		2011		% Change			2012		2011		% Change
Operating income (loss)	$	1,059.2	$	(5.8)		NM		$	1,090.6	$	(17.6)		NM
Add: Depreciation		35.2		42.4		(17)	%		71.3		86.8		(18)	%
Add: Amortization of intangible assets		9.8		26.7		(63)	%		19.6		50.9		(61)	%
Add: Restructuring costs		(0.1)		0.6		NM			7.3		28.4		(74)	%
Add: Equity-based compensation		8.6		11.0		(22)	%		17.2		21.4		(20)	%
Add: Asset impairments and write-offs		1.9		2.7		(30)	%		2.8		4.2		(33)	%
Add: Losses/(gains) on disposal of assets, net		(946.0)		(1.0)		NM			(946.4)		1.6		NM
Adjusted OIBDA	$	168.6	$	76.6		NM		$	262.4	$	175.7		49	%

Adjusted OIBDA increased for the three and six months ended June 30, 2012 as compared to the three and six months ended June 30, 2011 due primarily to the increase in operating income, driven by $96.0 million from licensing our retained patent portfolio. Adjusted OIBDA for the three and six months ended June 30, 2012 was negatively impacted by costs related to the proxy contest of $8.8 million and $10.6 million, respectively, costs related to the patent transaction of $5.6 million and $6.4 million, respectively, and $7.6 million and $9.6 million, respectively, of expense relating to the Virginia sales tax settlement in the second quarter of 2012.

Liquidity and Capital Resources

Current Financial Condition

Historically, the cash we generate has been sufficient to fund our working capital, capital expenditure and financing requirements. Forecasts of future cash flows are dependent on many factors, including future economic conditions and the execution of our strategy. We expect to fund our ongoing working capital, investing and financing requirements, including future repurchases of common stock, through our existing cash balance and cash flows from operations. Increases in cash flows from operations are achieved when growth from our online advertising services more than offsets the decline in domestic AOL-brand access subscribers. In order for us to achieve an increase in earnings from advertising services, we believe it will be important to increase the number and engagement of consumers who visit our properties, to enable us to increase our overall volume of display advertising sold, including through our higher-priced channels, and to maintain or increase pricing for advertising. Advertising revenues, however, are more unpredictable and variable than our subscription revenues, and are more likely to be adversely affected during economic downturns, as spending by advertisers tends to be cyclical in line with general economic conditions.

If we are unable to successfully implement our strategic plan and grow the earnings generated by our online advertising services, we may need to reassess our cost structure and/or seek other financing alternatives to fund our business. If it is necessary to seek other financing alternatives, our ability to obtain future financing will depend on, among other things, our financial condition and results of operations as well as the condition of the capital markets or other credit markets at the time we seek financing. Currently we do not have a credit rating from the credit rating agencies, so our access to the capital markets may be limited. As part of our ongoing assessment of our business and availability of capital and to enhance our liquidity position, we have divested of certain assets and product lines and may consider divesting of additional assets or product lines.

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PART I - ITEM 2. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND

RESULTS OF OPERATIONS

At June 30, 2012, our cash and equivalents totaled $1,468.5 million, as compared to $407.5 million at December 31, 2011. The increase in cash and equivalents was primarily due to the $1,056 million proceeds from the sale of the Sold Patents and the license of our retained patent portfolio to Microsoft. The proceeds are being invested in highly liquid short-term investments that are readily convertible to cash. Approximately 7% of our cash and equivalents as of June 30, 2012 is held internationally, primarily in United Kingdom, Canada, India and Japan, and is intended to be utilized to fund our foreign operations. Cash held internationally would have to be repatriated in order to be used to fund our domestic operations. If we were to repatriate funds, we would incur additional tax liabilities. We believe the cash balance in the U.S. is sufficient to fund our working capital needs.

On June 15, 2012, we sold approximately 800 of our patents and their related patent applications Microsoft and granted Microsoft a non-exclusive license to our retained patent portfolio, for aggregate proceeds of $1,056 million in cash. We currently intend to utilize the $1,056 million of proceeds to either repurchase outstanding shares or return to shareholders via other programs such as cash dividends. As part of that plan, on June 26, 2012 our Board of Directors approved a modified Dutch auction tender offer, which authorizes us to repurchase up to an aggregate of $400 million of our outstanding shares of common stock within a range of $27.00 to $30.00 per share of common stock. The tender offer commenced on June 28, 2012, and will expire at 5:00 p.m. ET on August 2, 2012, unless extended, amended or terminated earlier by AOL.

Summary Cash Flow Information

Our cash flows from operations are driven by net income adjusted for non-cash items such as depreciation, amortization, goodwill impairment, equity-based compensation expense and other activities impacting net income such as the gains and losses on the sale of assets or operating subsidiaries. Cash flows from investing activities consist primarily of the cash used in the acquisitions of various businesses as part of our strategy, proceeds received from the sale of assets or operating subsidiaries and cash used for capital expenditures. Capital expenditures and product development costs are mainly for the purchase of computer hardware, software, network equipment, furniture, fixtures and other office equipment. Cash flows from financing activities relate primarily to principal payments made on capital lease obligations and repurchases of common stock.

Operating Activities

The following table presents cash provided by operating activities for the periods presented (in millions):

	Six Months Ended June 30,
	2012		2011
Net income (loss)	$	991.6	$	(7.1)
Adjustments for non-cash and non-operating items:
Depreciation and amortization		90.9		137.7
Asset impairments and write-offs		2.8		4.2
(Gain) loss on step acquisition and disposal of assets, net		(956.6)		2.7
Equity-based compensation		17.2		21.4
Deferred income taxes		85.6		(14.2)
Other non-cash adjustments		(3.2)		4.8
All other, net, including working capital changes		(41.2)		(35.6)
Cash provided by operating activities	$	187.1	$	113.9

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Cash provided by operating activities increased $73.2 million for the six months ended June 30, 2012, as compared to the six months ended June 30, 2011, primarily due to the increase in operating income driven by the $96 million cash received from licensing our retained patent portfolio to Microsoft during the second quarter of 2012, partially offset by incentive compensation payments made in the first half of 2012 related to prior year acquisitions.

Investing Activities

The following table presents cash provided (used) by investing activities for the periods presented (in millions):

	Six Months Ended June 30,
	2012		2011
Investments and acquisitions, net of cash acquired	$	1.1	$	(372.2)
Proceeds from disposal of assets, net		960.5		1.3
Capital expenditures and product development costs		(31.7)		(53.9)
Cash provided (used) by investing activities	$	929.9	$	(424.8)

Cash provided by investing activities was $929.9 million for the six months ended June 30, 2012, as compared to cash used by investing activities of $424.8 million for the six months ended June 30, 2011. The $1,354.7 million increase in cash provided by investing activities was principally due to the $960 million in proceeds from the disposition of the Sold Patents in the second quarter of 2012, as well as the acquisitions of The Huffington Post and goviral during the six months ended June 30, 2011. The increase in cash provided by investing activities was also due to a decrease in capital expenditures and product development costs. In addition, investments and acquisitions, net of cash acquired, for the six months ended June 30, 2012 includes $6.9 million of cash acquired from the step acquisition of Ad.com Japan (net of $1.2 million cash paid for the additional 3% interest) during the first quarter of 2012.

Financing Activities

The following table presents cash used by financing activities for the periods presented (in millions):

	Six Months Ended June 30,
	2012		2011
Repurchase of common stock	$	(35.8)	$	-
Principal payments on capital leases		(28.1)		(24.3)
Tax withholdings related to net share settlements of restricted stock units		(6.1)		(0.2)
Decrease (increase) in cash collateral securing letters of credit		0.2		(12.7)
Proceeds from exercise of stock options		16.6		0.1
Cash used by financing activities	$	(53.2)	$	(37.1)

Cash used by financing activities was $53.2 million for the six months ended June 30, 2012, as compared to $37.1 million for the six months ended June 30, 2011. Cash used by financing activities for the six months ended June 30, 2012 includes $35.8 million related to the repurchase of our common stock, partially offset by $16.6 million cash provided by the exercise of stock options in the second quarter of 2012. See “Note 6” in our accompanying consolidated financial statements for further discussion of our stock repurchase program. Included in the cash used by financing activities for the six months ended June 30, 2011 was $12.7 million of cash collateral posted to secure letters of credit related to certain of our lease agreements.

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PART I - ITEM 2. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND

RESULTS OF OPERATIONS

Free Cash Flow

We use Free Cash Flow as a supplemental measure of our performance. We define Free Cash Flow as cash provided by operating activities, less capital expenditures, product development costs and principal payments on capital leases. We consider Free Cash Flow to be a liquidity measure that provides useful information to management and investors about the amount of cash generated by the business that, after capital expenditures, capitalized product development costs and principal payments on capital leases, can be used for strategic opportunities, including investing in our business, making strategic acquisitions and strengthening the balance sheet. Analysis of Free Cash Flow also facilitates management’s comparisons of our operating results to competitors’ operating results. A limitation on the use of this metric is that Free Cash Flow does not represent the total increase or decrease in cash for the period because it excludes certain non-operating cash flows.

Free Cash Flow is a non-GAAP financial measure and may be different than similarly-titled non-GAAP financial measures used by other companies. The presentation of this financial information is not intended to be considered in isolation or as a substitute for the financial information prepared and presented in accordance with GAAP.

The following table presents our reconciliation of Free Cash Flow to cash provided by operating activities (in millions):

	Six Months Ended June 30,
	2012		2011
Cash provided by operating activities	$	187.1	$	113.9
Less: Capital expenditures and product development costs		31.7		53.9
Less: Principal payments on capital leases		28.1		24.3
Free Cash Flow	$	127.3	$	35.7

Free Cash Flow increased $91.6 million for the six months ended June 30, 2012 as compared to the six months ended June 30, 2011. This increase is due to the increase in cash provided by operating activities, discussed in “Summary Cash Flow Information—Operating Activities” above and due to reduced capital expenditures and product development costs, slightly offset by an increase in principal payments on capital leases.

Customer Credit Risk

Customer credit risk represents the potential for financial loss if a customer is unwilling or unable to meet its agreed-upon contractual payment obligations. Credit risk originates from sales of advertising and subscription access service and is dispersed among many different counterparties. No single customer had a receivable balance at June 30, 2012 greater than 10% of total net receivables.

Customer credit risk is monitored on a company-wide basis. We maintain a comprehensive approval process prior to issuing credit to third-party customers. On an ongoing basis, we track customer exposure based on news reports, rating agency information and direct dialogue with customers. Counterparties that are determined to be of a higher risk are evaluated to assess whether the payment terms previously granted to them should be modified. We also continuously monitor payment levels from customers, and a provision for estimated uncollectible amounts is maintained based on historical experience and any specific customer collection issues that have been identified. While such uncollectible amounts have historically been within our expectations and

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related reserve balances, if there is a significant change in uncollectible amounts in the future or the financial condition of our counterparties across various industries or geographies deteriorates further, additional reserves may be required.

Critical Accounting Policies

Our consolidated financial statements are prepared in accordance with GAAP, which require management to make estimates, judgments and assumptions that affect the amounts reported in the consolidated financial statements and the accompanying notes. Management considers an accounting policy to be critical if it is important to our financial condition and results of operations and if it requires significant judgment and estimates on the part of management in its application. The development and selection of these critical accounting policies have been determined by our management. Due to the significant judgment involved in selecting certain of the assumptions used in these areas, it is possible that different parties could choose different assumptions and reach different conclusions. We consider the policies related to the following matters to be critical accounting policies: (a) gross versus net revenue recognition; (b) impairment of goodwill; and (c) income taxes.

For additional information about our critical accounting policies and our significant accounting policies, see “Item 7—MD&A—Critical Accounting Policies” and “Note 1” to our audited consolidated financial statements in our Annual Report. There have been no significant changes to our critical accounting policies disclosed in our Annual Report for the year ended December 31, 2011.

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ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

There have been no material changes in market risk from the information provided in Part II, Item 7A. “Quantitative and Qualitative Disclosures About Market Risk” in our Annual Report on Form 10-K for the year ended December 31, 2011.

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ITEM 4. CONTROLS AND PROCEDURES

Evaluation of Disclosure Controls and Procedures

Disclosure controls and procedures include, without limitation, controls and procedures designed to ensure that the information we are required to disclose in our financial reports is recorded, processed, summarized and reported within the time periods specified by the SEC rules and forms, and that such information is accumulated and communicated to senior management, as appropriate, to allow timely decisions regarding required disclosure. Management is responsible for establishing and maintaining effective disclosure controls and procedures, as defined under Rules 13a-15(e) and 15d-15(e) of the Securities Exchange Act of 1934, as amended. Any controls and procedures, no matter how well designed and operated, can provide only reasonable assurance of achieving the desired control objectives. Our management, with the participation of our Chief Executive Officer and Chief Operating Officer and Acting Chief Financial Officer, evaluated the effectiveness of the design and operation of our disclosure controls and procedures as of June 30, 2012. Based on that evaluation, our Chief Executive Officer and Chief Operating Officer and Acting Chief Financial Officer concluded that our disclosure controls and procedures were effective as of June 30, 2012, at a reasonable assurance level.

Changes to Internal Control Over Financial Reporting

We have evaluated the changes in our internal control over financial reporting that occurred during the three and six months ended June 30, 2012 and concluded that there have not been any changes that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.

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ITEM 1. FINANCIAL STATEMENTS

CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME

(Unaudited; In millions, except per share amounts)

	Three Months Ended         June 30,						Six Months Ended         June 30,
	2012			2011			2012			2011
Revenues:
Advertising	$	337.8		$	319.0		$	667.9		$	632.7
Subscription		175.5			201.3			357.6			416.7
Other		17.8			21.9			35.0			44.2
Total revenues		531.1			542.2			1,060.5			1,093.6
Costs of revenues		396.2			403.4			780.8			792.3
General and administrative		107.8			117.3			204.0			238.0
Amortization of intangible assets		9.8			26.7			19.6			50.9
Restructuring costs		(0.1	)		0.6			7.3			28.4
Income from licensing of intellectual property		(96.0	)		-			(96.0	)		-
(Gain) loss on disposal of assets, net		(945.8	)		-			(945.8	)		1.6
Operating income (loss)		1,059.2			(5.8	)		1,090.6			(17.6	)
Other income (loss), net		(1.1	)		(1.7	)		7.3			(1.1	)
Income (loss) from operations before income taxes		1,058.1			(7.5	)		1,097.9			(18.7	)
Income tax provision (benefit)		87.5			4.3			106.3			(11.6	)
Net income (loss)	$	970.6		$	(11.8	)	$	991.6		$	(7.1	)
Net (income) loss attributable to noncontrolling interests		0.2			-			0.3			-
Net income (loss) attributable to AOL Inc.	$	970.8		$	(11.8	)	$	991.9		$	(7.1	)
Per share information attributable to AOL Inc. common stockholders:
Basic net income (loss) per common share	$	10.37		$	(0.11	)	$	10.55		$	(0.07	)
Diluted net income (loss) per common share	$	10.17		$	(0.11	)	$	10.42		$	(0.07	)
Shares used in computing basic income (loss) per common share		93.6			107.0			94.0			106.9
Shares used in computing diluted income (loss) per common share		95.5			107.0			95.2			106.9
Comprehensive income (loss) attributable to AOL Inc.:
Comprehensive income (loss)	$	957.3		$	(4.3	)	$	977.4		$	7.7
Comprehensive (income) loss attributable to noncontrolling interests		(0.3	)		-			0.5			-
Comprehensive income (loss) attributable to AOL Inc.	$	957.0		$	(4.3	)	$	977.9		$	7.7

See accompanying notes.

22

AOL INC.

ITEM 1. FINANCIAL STATEMENTS

CONSOLIDATED BALANCE SHEETS

(In millions, except per share amounts)

	June 30,    2012		December 31, 2011
	(unaudited)
Assets
Current assets:
Cash and equivalents	$	1,468.5	$	407.5
Accounts receivable, net of allowances of $7.9 and $8.3, respectively		296.8		311.5
Prepaid expenses and other current assets		31.0		36.9
Deferred income taxes		40.5		53.7
Total current assets		1,836.8		809.6
Property and equipment, net		490.4		505.2
Goodwill		1,067.4		1,064.0
Intangible assets, net		133.7		135.2
Long-term deferred income taxes		184.4		259.2
Other long-term assets		63.0		51.8
Total assets	$	3,775.7	$	2,825.0
Liabilities and Equity
Current liabilities:
Accounts payable	$	73.6	$	74.9
Accrued compensation and benefits		95.3		152.8
Accrued expenses and other current liabilities		182.5		171.6
Deferred revenue		68.4		70.9
Current portion of obligations under capital leases		45.8		44.6
Total current liabilities		465.6		514.8
Long-term portion of obligations under capital leases		62.6		66.2
Long-term deferred income taxes		7.5		3.5
Other long-term liabilities		78.4		67.9
Total liabilities		614.1		652.4
Commitments and contingencies (see Note 9)
Redeemable noncontrolling interest (see Note 1)		14.2		-
Equity:
Common stock, $0.01 par value, 108.7 million shares issued and 93.9 million shares outstanding as of June 30, 2012 and 107.0 million shares issued and 94.3 million shares outstanding as of December 31, 2011		1.1		1.1
Additional paid-in capital		3,455.3		3,422.4
Accumulated other comprehensive income (loss), net		(301.5)		(287.5)
Retained earnings (accumulated deficit)		202.1		(789.8)
Treasury stock, at cost, 14.8 million shares at June 30, 2012 and 12.7 million shares at December 31, 2011		(209.4)		(173.6)
Total stockholders’ equity		3,147.6		2,172.6
Noncontrolling interest		(0.2)		-
Total equity		3,147.4		2,172.6
Total liabilities, redeemable noncontrolling interest and equity	$	3,775.7	$	2,825.0

See accompanying notes.

23

AOL INC.

ITEM 1. FINANCIAL STATEMENTS

CONSOLIDATED STATEMENTS OF CASH FLOWS

(Unaudited; In millions)

	Six Months Ended June 30,
	2012		2011
Operating Activities
Net income (loss)	$	991.6	$	(7.1)
Adjustments for non-cash and non-operating items:
Depreciation and amortization		90.9		137.7
Asset impairments and write-offs		2.8		4.2
(Gain) loss on step acquisition and disposal of assets, net		(956.6)		2.7
Equity-based compensation		17.2		21.4
Deferred income taxes		85.6		(14.2)
Other non-cash adjustments		(3.2)		4.8
Changes in operating assets and liabilities, net of acquisitions		(41.2)		(35.6)
Cash provided by operating activities		187.1		113.9
Investing Activities
Investments and acquisitions, net of cash acquired		1.1		(372.2)
Proceeds from disposal of assets, net		960.5		1.3
Capital expenditures and product development costs		(31.7)		(53.9)
Cash provided (used) by investing activities		929.9		(424.8)
Financing Activities
Repurchase of common stock		(35.8)		-
Principal payments on capital leases		(28.1)		(24.3)
Tax withholdings related to net share settlements of restricted stock units		(6.1)		(0.2)
Decrease (increase) in cash collateral securing letters of credit		0.2		(12.7)
Proceeds from exercise of stock options		16.6		0.1
Cash used by financing activities		(53.2)		(37.1)
Effect of exchange rate changes on cash and equivalents		(2.8)		4.9
Increase (decrease) in cash and equivalents		1,061.0		(343.1)
Cash and equivalents at beginning of period		407.5		801.8
Cash and equivalents at end of period	$	1,468.5	$	458.7
Supplemental disclosures of cash flow information
Cash paid for interest	$	3.0	$	3.1
Cash paid for income taxes	$	3.9	$	9.0

See accompanying notes.

24

AOL INC.

ITEM 1. FINANCIAL STATEMENTS

CONSOLIDATED STATEMENTS OF EQUITY

(Unaudited; In millions)

	Common Stock				Additional Paid-In Capital		Accumulated Other Comprehensive Income (Loss), Net		Retained Earnings (Accumulated Deficit)		Treasury Stock, at Cost		Non- Controlling Interest		Total Equity
	Shares		Amount
Balance at December 31, 2010		106.7	$	1.1	$	3,376.6	$	(287.9)	$	(802.9)	$	-	$	-	$	2,286.9
Net loss		-		-		-		-		(7.1)		-		-		(7.1)
Foreign currency translation adjustments		-		-		-		14.8		-		-		-		14.8
Comprehensive income (loss)		-		-		-		14.8		(7.1)		-		-		7.7
Amounts related to equity-based compensation, net of tax withholdings (See Note 6)		-		-		28.7		-		-		-		-		28.7
Issuance of common stock		0.3		-		0.2		-		-		-		-		0.2
Balance at June 30, 2011		107.0	$	1.1	$	3,405.5	$	(273.1)	$	(810.0)	$	-	$	-	$	2,323.5
Balance at December 31, 2011		94.3	$	1.1	$	3,422.4	$	(287.5)	$	(789.8)	$	(173.6)	$	-	$	2,172.6
Net income (loss)		-		-		-		-		991.9		-		(0.2)		991.7
Unrealized gain on equity method investments		-		-		-		0.1		-		-		-		0.1
Foreign currency translation adjustments		-		-		-		(14.1)		-		-		-		(14.1)
Comprehensive income (loss)		-		-		-		(14.0)		991.9		-		(0.2)		977.7
Amounts related to equity-based compensation, net of tax withholdings		-		-		16.3		-		-		-		-		16.3
Issuance of common stock		1.7		-		16.6		-		-		-		-		16.6
Repurchase of common stock		(2.1)		-		-		-		-		(35.8)		-		(35.8)
Balance at June 30, 2012		93.9	$	1.1	$	3,455.3	$	(301.5)	$	202.1	$	(209.4)	$	(0.2)	$	3,147.4

See accompanying notes.

25

AOL INC.

NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS

NOTE 1—DESCRIPTION OF BUSINESS, BASIS OF PRESENTATION AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES

Description of Business

For a description of the business of AOL Inc. (“AOL” or the “Company”), see “Note 1” to the Company’s audited consolidated financial statements included in the Company’s Annual Report on Form 10-K for the year ended December 31, 2011 (the “Annual Report”).

Basis of Presentation

Basis of Consolidation

The consolidated financial statements include 100% of the assets, liabilities, revenues, expenses and cash flows of AOL and all voting interest entities in which AOL has a controlling voting interest (“subsidiaries”) and variable interest entities in which AOL is the primary beneficiary in accordance with the consolidation accounting guidance. Intercompany accounts and transactions between consolidated companies have been eliminated in consolidation. The consolidated balances of the Company’s variable interest entities are not material to the Company’s consolidated financial statements for the periods presented.

The financial position and operating results of the majority of AOL’s foreign operations are consolidated using the local currency as the functional currency. Local currency assets and liabilities are translated at the rates of exchange on the balance sheet date, and local currency revenues and expenses are translated at average rates of exchange during the period. Resulting translation gains or losses are included in the consolidated balance sheet as a component of accumulated other comprehensive income (loss), net.

Redeemable Noncontrolling Interest

The noncontrolling interest in a joint venture between Mitsui & Company Ltd. (“Mitsui”) and AOL (“Ad.com Japan”) is classified outside of permanent equity in the Company’s consolidated balance sheet as of June 30, 2012, due to a redemption right available to the noncontrolling interest holder in the future. The noncontrolling interest holder’s right to redeem its stock is exercisable any time between July 1 and July 30 of any year, commencing with July 1, 2014. Net income in the consolidated statement of comprehensive income for the three and six months ended June 30, 2012 reflects 100 percent of the results of Ad.com Japan as the Company has a controlling interest in the entity. Net income is subsequently adjusted to exclude AOL’s noncontrolling interests to arrive at net income attributable to AOL Inc.

Changes in Basis of Presentation

The Company has changed the classification of certain amounts within the accompanying consolidated statement of cash flows for the six months ended June 30, 2011. The revisions related to accrued liabilities and capital expenditures do not have a material impact on the consolidated statement of cash flows.

Use of Estimates

The preparation of the financial statements in conformity with U.S. generally accepted accounting principles (“GAAP”) requires management to make estimates, judgments and assumptions that affect the amounts reported in the consolidated financial statements and footnotes thereto. Actual results could differ from those estimates. Significant estimates inherent in the preparation of the consolidated financial statements include asset impairments, reserves established for doubtful accounts, equity-based compensation, depreciation and amortization, business combinations, income taxes, litigation matters and contingencies.

26

AOL INC.

NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS

Interim Financial Statements

The interim consolidated financial statements are unaudited; however, in the opinion of management, they contain all the adjustments (consisting of those of a normal recurring nature) considered necessary to present fairly the financial position, the results of operations and cash flows for the periods presented in conformity with GAAP applicable to interim periods. The interim consolidated financial statements should be read in conjunction with the audited consolidated financial statements of AOL in the Annual Report.

Information about Geographical Areas

Revenues in different geographical areas are as follows (in millions):

	Three Months Ended June 30, (a)				Six Months Ended June 30, (a)
	2012		2011		2012		2011
United States	$	474.4	$	491.1	$	950.8	$	997.6
United Kingdom		23.4		23.9		47.6		46.9
Germany		8.1		8.9		17.1		17.1
Canada		9.7		9.5		17.0		17.9
Japan		8.0		0.3		14.9		0.5
Other international		7.5		8.5		13.1		13.6
Total international		56.7		51.1		109.7		96.0
Total	$	531.1	$	542.2	$	1,060.5	$	1,093.6

(a) Revenues are attributed to countries based on the location of customers.

Recent Accounting Standards

Goodwill Impairment

In September 2011, new guidance was issued related to assessing goodwill impairment. Under the new guidance, a company is permitted to make a qualitative assessment of whether goodwill impairment exists before applying the two-step goodwill impairment test. If the conclusion from the qualitative assessment is that it is more likely than not that the fair value of a reporting unit is less than its carrying amount, the company would be required to conduct the current two-step goodwill impairment test. Otherwise, it would not need to apply the two-step test.

This new guidance became effective for the Company in January 2012. Given the proximity of the book value and fair value of the Company’s sole reporting unit as of the date of its 2011 annual goodwill impairment test, this guidance is not expected to result in a material change to the way the Company performs its analysis for goodwill.

27

AOL INC.

NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS

NOTE 2—INCOME (LOSS) PER COMMON SHARE

Basic income (loss) per common share is calculated by dividing net income (loss) attributable to AOL Inc. common stockholders by the weighted average number of shares of common stock outstanding during the reporting period. Diluted income (loss) per common share is calculated to give effect to all potentially dilutive common shares that were outstanding during the reporting period. The dilutive effect of outstanding equity-based compensation awards is reflected in diluted income (loss) per common share by application of the treasury stock method, only in periods in which such effect would have been dilutive for the period.

For the three and six months ended June 30, 2012, the Company had 2.6 million and 6.9 million, respectively, of weighted-average potentially dilutive common shares that were not included in the computation of diluted earnings per share because to do so would be anti-dilutive for that period. For the three and six months ended June 30, 2011, the Company had 9.9 million and 8.6 million, respectively, of weighted-average potentially dilutive common shares that were not included in the computation of diluted earnings per share because to do so would be anti-dilutive for that period.

The following table is a reconciliation of basic and diluted net income (loss) attributable to AOL Inc. common stockholders per common share (in millions, except per share amounts):

	Three Months Ended June 30,				Six Months Ended June 30,
	2012		2011		2012		2011
Net income (loss) attributable to AOL Inc. common stockholders	$	970.8	$	(11.8)	$	991.9	$	(7.1)
Shares used in computing basic income per common share		93.6		107.0		94.0		106.9
Dilutive effect of equity-based awards		1.9		-		1.2		-
Shares used in computing diluted income per common share		95.5		107.0		95.2		106.9
Basic net income (loss) per common share	$	10.37	$	(0.11)	$	10.55	$	(0.07)
Diluted net income (loss) per common share	$	10.17	$	(0.11)	$	10.42	$	(0.07)

NOTE 3—GOODWILL

A summary of changes in the Company’s goodwill during the six months ended June 30, 2012 is as follows (in millions):

	Gross Goodwill		Impairments		Net Goodwill
December 31, 2011	$	36,689.1	$	(35,625.1)	$	1,064.0
Acquisitions		10.9		-		10.9
Translation adjustments		(7.5)		-		(7.5)
June 30, 2012	$	36,692.5	$	(35,625.1)	$	1,067.4

The increase in goodwill for the six months ended June 30, 2012 was due primarily to AOL’s purchase of a controlling interest in Ad.com Japan. See “Note 4” for additional information on this acquisition.

28

AOL INC.

NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS

NOTE 4—BUSINESS ACQUISITIONS, DISPOSITIONS AND OTHER SIGNIFICANT TRANSACTIONS

Ad.com Japan

On February 9, 2012, AOL entered into a share-purchase agreement with Mitsui to purchase an additional 3% interest in Ad.com Japan for approximately $1.2 million. Ad.com Japan, which operates a display advertising network business in Japan, was formed in 2006. Prior to the execution of the share purchase agreement, AOL and Mitsui each owned a 50% interest in Ad.com Japan, and AOL accounted for its 50% interest using the equity method of accounting. As part of this transaction, AOL obtained control of the board and of the day-to-day operations of Ad.com Japan. AOL has accounted for the incremental 3% share purchase as a business combination achieved in stages (“step acquisition”) and consolidated Ad.com Japan beginning on February 9, 2012 (“the closing date”).

Under the accounting guidance for step acquisitions, AOL is required to record all assets acquired, liabilities assumed, and Mitsui’s noncontrolling interests at fair value, and recognize the entire goodwill of the acquired business. The step acquisition guidelines also require that AOL remeasure its preexisting investment in Ad.com Japan at fair value, and recognize any gains or losses from such remeasurement. The fair value of AOL’s interest immediately before the closing date was $15.4 million, which resulted in the Company recognizing a non-cash gain of approximately $10.8 million within other income (loss), net on the consolidated statement of comprehensive income in the first quarter of 2012. The Company used a combination of the market based approach (guideline public company) and an income approach (discounted cash flow analysis), both of which represent level 3 fair value measurements, to measure both the fair value of AOL’s preexisting investment and the fair value of Mitsui’s noncontrolling interest. As Mitsui has a right to put its interest to AOL based on a pre-established and determinable price in the future, the noncontrolling interest is presented as redeemable noncontrolling interest outside permanent equity in the Company’s consolidated balance sheet. The noncontrolling interest holder’s right to redeem its stock is exercisable any time between July 1 and July 30 of any year, commencing with July 1, 2014. The amount payable from AOL to Mitsui if Mitsui were to exercise its redemption right is determined by taking the sum of ¥2,000,000,000 (approximately $26.0 million as of the closing date) plus any incremental cash over the $7.8 million cash balance at December 31, 2011, and multiplying that total by Mitsui’s percentage ownership of Ad.com Japan (47% at closing). The Company has elected to recognize changes in the redemption value as they occur; however, this has no impact on the carrying value of Mitsui’s interest in Ad.com Japan because it exceeds the current redemption value. As of June 30, 2012 the undiscounted redemption value of the put option held by Mitsui was calculated to be approximately $12.3 million, which is below the $14.2 million carrying value of Mitsui’s interest in Ad.com Japan.

AOL recorded $9.7 million of goodwill (which is not deductible for tax purposes) and $19.2 million of intangible assets associated with this acquisition. The intangible assets associated with this acquisition consist primarily of trade names to be amortized on a straight-line basis over a period of ten years and advertiser relationships to be amortized over a period of five years. The fair value of the significant identified intangible assets was estimated by using relief from royalty, cost savings and multi-period excess earnings valuation methodologies, which represent level 3 fair value measurements. Inputs used in the methodologies primarily included projected future cash flows, discounted at a rate commensurate with the risk involved.

Unaudited pro forma results of operations assuming this acquisition had taken place at the beginning of each period are not provided because the historical operating results of the acquired company were not significant and pro forma results would not be significantly different from reported results for the periods presented.

29

AOL INC.

NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS

Patent Portfolio Sale and License

On June 15, 2012, the Company sold approximately 800 patents and their related patent applications (the “Sold Patents”) to Microsoft Corporation, a Washington corporation (“Microsoft”), and granted Microsoft a non-exclusive license to the Company’s retained patent portfolio, for aggregate proceeds of $1,056 million in cash (excluding transaction costs). The transaction was structured as a sale of all of the outstanding shares of a wholly owned non-operating subsidiary and the direct sale of certain other patents not held by the subsidiary. The Company concluded that immediate recognition of all of the proceeds was appropriate as the Company has no ongoing performance obligations with respect to the sold or licensed patents.

The disposed assets had a carrying value of $4.0 million on the Company’s balance sheet and accordingly, the Company recorded a gain on the disposition of the Sold Patents of $945.8 million (which represents the consideration allocated to the sale less the carrying value of the disposed assets and transaction costs that were contingent on closing). With respect to the licensing portion of the transaction, the Company recognized income from licensing its retained patent portfolio of $96 million for the three months ended June 30, 2012.

Based on the anticipated utilization of existing deferred tax assets and the fact that the disposition of the Sold Patents generated a capital loss (which is subject to a full valuation allowance), the Company does not expect the $1,056 million in proceeds to result in material cash taxes.

NOTE 5—INCOME TAXES

The Company recorded pre-tax income from operations of $1,058.1 million and related income tax expense of $87.5 million, which resulted in an effective tax rate of 8.3% for the three months ended June 30, 2012, as compared to a negative effective tax rate of 57.3% for the three months ended June 30, 2011. The effective tax rate for the three months ended June 30, 2012 differed substantially from the statutory U.S. federal income tax rate of 35.0% primarily due to the tax impact of the patent transaction with Microsoft. The patent transaction consisted of two elements: first, the sale of patents and the stock of a subsidiary, and second, the licensing of AOL’s retained patent portfolio, resulting in pre-tax income of $1,041.8 million. No material cash taxes will be paid, due to existing net operating losses which offset substantially all of the ordinary income. However, for book purposes, this transaction resulted in income tax expense of $71.5 million. The tax expense relates primarily to ordinary income realized on the transaction, the majority of which is due to the licensing portion. In addition, the transaction created a significant capital loss due to the tax basis in the disposed subsidiary. The Company does not believe it is currently more likely than not that this capital loss will be realized, and accordingly, has recorded a full valuation allowance on the capital loss generated by the patent transaction. In addition to the impacts of the patent transaction on income tax expense, the Company also had foreign losses that did not produce a tax benefit.

The Company recorded pre-tax income from operations of $1,097.9 million and related income tax expense of $106.3 million, which resulted in an effective tax rate of 9.7% for the six months ended June 30, 2012, as compared to the effective tax rate of 62.0% for the six months ended June 30, 2011. The effective tax rate for the six months ended June 30, 2012 differed substantially from the statutory U.S. federal income tax rate of 35.0% primarily due to the tax impact of the patent transaction with Microsoft, described above. In addition to the impacts of the patent transaction on income tax expense, the Company also had foreign losses that did not produce a tax benefit. The effective tax rate for the six months ended June 30, 2011 differed from the statutory U.S. federal income tax rate of 35.0% primarily due to $7.1 million of income tax benefit associated with a worthless stock deduction related to the sale of a subsidiary in the first quarter of 2011 and favorable adjustments of $8.0 million related to escrow disbursements from prior acquisitions for which AOL concluded a tax benefit could be recognized.

30

AOL INC.

NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS

NOTE 6—STOCKHOLDERS’ EQUITY

AOL is authorized to issue up to 660.0 million shares of all classes of stock, consisting of 60.0 million shares of preferred stock, par value $0.01 per share (“Preferred Stock”), and 600.0 million shares of common stock, par value $0.01 per share. Rights and privileges associated with shares of Preferred Stock are subject to authorization by the Company’s Board of Directors and may differ from those of any and all other series at any time outstanding. All shares of common stock will be identical and will entitle the holders thereof to the same rights and privileges.

As of June 30, 2012, 108,732,847 shares of common stock were issued and 93,906,059 shares of common stock were outstanding. No dividends were declared or paid for the six months ended June 30, 2012.

During the six months ended June 30, 2011, the Company recorded $28.7 million of equity-based compensation that resulted in an increase in additional paid-in capital. Included in this amount was $21.4 million related to expense incurred under AOL’s equity-based compensation plan, $3.6 million related to the fair value of unvested Huffington Post Plan options held by The Huffington Post employees that were converted into AOL stock options and related to pre-combination service, as well as $4.0 million related to the accelerated vesting of stock options related to terminated employees.

Stock Repurchase Program

On August 10, 2011, the Company’s Board of Directors approved a stock repurchase program, which authorizes the Company to repurchase up to $250.0 million of its outstanding shares of common stock from time to time through August 2012. Repurchases are subject to market conditions, share price and other factors. Repurchases have been and will be made in accordance with applicable securities laws in the open market or in private transactions and may include derivative transactions, or pursuant to any trading plan adopted in accordance with Rule 10b5-1 of the Securities and Exchange Commission. For the six months ended June 30, 2012, the Company paid $35.8 million to repurchase 2.1 million shares at a weighted average price of $17.29 per share as part of this program. From August 10, 2011 through June 30, 2012, the Company repurchased a total of 14.8 million shares at a weighted average price of $14.11 per share as part of this program, for total consideration of $209.4 million. Shares repurchased under the program are recorded as treasury stock on the Company’s consolidated balance sheet. The repurchase program may be suspended or discontinued at any time. The shares repurchased during the six months ended June 30, 2012 were not the result of an accelerated share repurchase agreement and did not result in any derivative transactions. Management has not made a decision on whether shares purchased under this program will be retired or reissued.

Dutch Auction Tender Offer

On June 28, 2012, AOL announced the first step in the multi-stage process of returning 100% of the patent transaction proceeds to shareholders through a $400.0 million modified Dutch auction tender offer. The $400.0 million aggregate purchase price of shares of common stock sought in the tender offer includes the approximately $40.0 million remaining from the initial $250.0 million stock repurchase program discussed above. The tender offer began on the date of the announcement, June 28, 2012, and will expire on August 2, 2012 unless extended, amended or terminated earlier. Through the Dutch tender offer, AOL’s shareholders will have the opportunity to tender some or all of their shares at a price within the range of $27.00 to $30.00 per share. Shares repurchased under the program will be recorded as treasury stock on the Company’s consolidated balance sheet.

31

AOL INC.

NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS

NOTE 7—EQUITY-BASED COMPENSATION

Pursuant to the Company���s Amended and Restated 2010 Stock Incentive Plan (“2010 SIP”) stock options are granted to employees, advisors and non-employee directors of AOL with exercise prices equal to the quoted market value of the common stock at the date of grant. Performance stock options are also granted to certain senior level executives. Generally, the stock options vest ratably over a three to four year vesting period and expire ten years from the date of grant. Certain stock option awards provide for accelerated vesting upon an election to retire after reaching a specified age and years of service, as well as certain additional circumstances for non-employee directors.

Also pursuant to the 2010 SIP, AOL may also grant shares of common stock, restricted stock units (“RSUs”) or performance stock units (“PSUs”) to its employees, advisors and non-employee directors, which generally vest ratably over a three to four year period from the date of grant. Holders of restricted stock, RSU and PSU awards are generally entitled to receive regular cash dividends or dividend equivalents, respectively, at the discretion of the Board of Directors, if paid by the Company during the period of time that the restricted stock, RSU or PSU awards are unvested. Certain of the Company’s PSU awards are subject to quarterly remeasurement of expense with corresponding adjustments to cumulative recognized compensation expense, as the service inception date precedes the grant date for these awards.

The Company is authorized to grant equity awards to employees, advisors and non-employee directors covering an aggregate of 21.8 million shares of AOL common stock under the 2010 SIP. Shares that are subject to Restricted Stock Awards or Other Stock-Based Awards (as such terms are defined in the 2010 SIP) shall be counted against the share authorization limit and the per participant limit as 1.61 shares for every share granted. Amounts available for issuance pursuant to grants under the 2010 SIP will change over time based on such activities as the conversion of equity awards into common stock, the forfeiture of equity awards and the cancellation of equity awards, among other activities.

Upon the (i) exercise of a stock option award, (ii) vesting of a RSU, (iii) grant of restricted stock or (iv) vesting of a performance share, shares of AOL common stock are issued from authorized but unissued shares or from treasury stock.

Equity-Based Compensation Expense

Compensation expense recognized by AOL related to its equity-based compensation plans is as follows (in millions):

	Three Months Ended June 30,				Six Months Ended June 30,
	2012		2011		2012		2011
Stock options	$	4.5	$	5.7	$	8.8	$	10.6
RSUs and PSUs		4.1		5.3		8.4		10.8
Total equity-based compensation expense	$	8.6	$	11.0	$	17.2	$	21.4
Tax benefit recognized	$	3.4	$	4.3	$	6.8	$	8.4

As of June 30, 2012, the Company had 7.8 million stock options and 3.4 million RSUs/PSUs outstanding to employees, advisors and non-employee directors. The weighted-average exercise price of the stock options and the weighted-average grant date fair value of the RSUs/PSUs outstanding as of June 30, 2012 were $20.64 and $21.61, respectively.

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AOL INC.

NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS

As of June 30, 2012, total unrecognized compensation cost related to unvested AOL stock option awards was $30.6 million and is expected to be recognized over a weighted-average period of approximately 2.5 years. Total unrecognized compensation cost as of June 30, 2012 related to unvested RSUs/PSUs was $52.3 million and is expected to be recognized over a weighted-average period of approximately 2.6 years. To the extent the actual forfeiture rate is different from what the Company has estimated, equity-based compensation expense related to these awards will be different from the Company’s expectations.

AOL Stock Options

The assumptions presented in the table below represent the weighted-average value of the applicable assumption used to value AOL stock options at their grant date:

	Six Months Ended June 30,
	2012		2011
Expected volatility		39.6%		36.7%
Expected term to exercise from grant date		5.33 years		5.50 years
Risk-free rate		0.9%		2.5%
Expected dividend yield		0.0%		0.0%

The assumptions above relate to AOL stock options granted during the period. The assumptions for 2011 do not include stock options that were converted in connection with the acquisition of The Huffington Post during the six months ended June 30, 2011.

NOTE 8—RESTRUCTURING COSTS

For the three months ended June 30, 2012, the Company recorded a reduction to expense of $0.1 million related primarily to changes in previous estimates of restructuring costs. For the six months ended June 30, 2012, the Company incurred $7.3 million of restructuring costs related to organizational changes made in an effort to improve its ability to execute its strategy.

A summary of AOL’s restructuring activity for the six months ended June 30, 2012 is as follows (in millions):

	Employee Terminations		Other Exit Costs		Total
Liability at December 31, 2011	$	5.6	$	7.1	$	12.7
Restructuring expense		7.7		(0.4)		7.3
Foreign currency translation and other adjustments		0.9		0.2		1.1
Cash paid		(12.1)		(3.0)		(15.1)
Liability at June 30, 2012	$	2.1	$	3.9	$	6.0

At June 30, 2012, of the remaining liability of $6.0 million, $5.6 million was classified as a current liability within accrued expenses and other current liabilities, with the remaining $0.4 million classified within other long-term liabilities in the consolidated balance sheet. Amounts classified as long-term are expected to be paid through 2014.

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AOL INC.

NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS

NOTE 9 – COMMITMENTS AND CONTINGENCIES

Commitments

For a description of AOL’s commitments see “Note 10” to the Company’s audited consolidated financial statements included in the Annual Report.

Contingencies

During the second quarter of 2012, the Company paid $13.5 million to settle a sales tax matter with the Virginia Department of Taxation covering the period from February 1995 through December 2011. In connection with the resolution of this matter, the Company recorded incremental sales and use tax expense within general & administrative expense of $7.6 million and $9.6 million for the three and six months ended June 30, 2012, respectively.

AOL is a party to a variety of claims, suits and proceedings that arise in the normal course of business, including actions with respect to intellectual property claims, tax matters, labor and unemployment claims, commercial claims, claims related to the Company’s business model for content creation and other matters. With respect to tax matters, AOL has received tax assessments in certain states related to sales and use taxes on its business operations. AOL has appealed these tax assessments and plans to vigorously contest these matters. In addition, AOL has received assessments in certain foreign countries related to income tax and transfer pricing, and plans to vigorously contest these matters as well. In certain instances, the Company was required to pay a portion of the tax assessment in order to proceed with the dispute of the assessment. While the results of such normal course claims, suits and proceedings cannot be predicted with certainty, management does not believe that, based on current knowledge and the likely timing of resolution of the various matters, any additional reasonably possible potential losses above the amount accrued for such matters would be material to the Company’s financial statements. Regardless of the outcome, legal proceedings can have an adverse effect on us because of defense costs, diversion of management resources and other factors.

NOTE 10—SEGMENT INFORMATION

An operating segment is defined as a component of an enterprise that engages in business activities from which it may earn revenues and incur expenses and that has discrete financial information that is regularly reviewed by the chief operating decision maker in deciding how to allocate resources and in assessing performance.

On June 29, 2012, the Company announced a plan to form operating units in conjunction with a planned change in management structure. However, the planned operating units are still being finalized, and there is currently no financial data regularly reviewed by the Company’s chief operating decision maker, its Chief Executive Officer, below the consolidated unit level. The organizational changes announced on June 29, 2012 did not impact the Company’s conclusion that the chief operating decision maker is its Chief Executive Officer as of and for the six months ended June 30, 2012. The chief operating decision maker continues to evaluate performance and make operating decisions about allocating resources based on financial data presented on a consolidated basis. There are no executives who are held accountable by AOL’s chief operating decision maker, or anyone else, for an operating measure of profit or loss for any operating unit below the consolidated unit level. Accordingly, management has determined that the Company has one segment as of and for the six months ended June 30, 2012.

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AOL INC.

PART II. OTHER INFORMATION

ITEM 1.        LEGAL PROCEEDINGS

During the second quarter of 2012, we paid $13.5 million to settle a sales tax matter with the Virginia Department of Taxation covering the period from February 1995 through December 2011. In connection with the resolution of this matter, we recorded incremental sales and use tax expense within general & administrative expense of $7.6 million and $9.6 million for the three and six months ended June 30, 2012, respectively.

We are a party to a variety of claims, suits and proceedings that arise in the normal course of business, including actions with respect to intellectual property claims, tax matters, labor and unemployment claims, commercial claims, claims related to our business model for content creation and other matters. With respect to tax matters, we have received tax assessments in certain states related to sales and use taxes on our business operations. We have appealed these tax assessments and plan to vigorously contest these matters. In addition, we have received assessments in certain foreign countries related to income tax and transfer pricing, and plan to vigorously contest these matters as well. In certain instances, we were required to pay a portion of the tax assessment in order to proceed with the dispute of the assessment. While the results of such normal course claims, suits and proceedings cannot be predicted with certainty, management does not believe that, based on current knowledge and the likely timing of resolution of various matters, any additional reasonably possible potential losses above the amount accrued for such matters would be material to our financial statements. Regardless of the outcome, legal proceedings can have an adverse effect on us because of defense costs, diversion of management resources and other factors. See “Item 1A—Risk Factors—Risks Relating to Our Business—If we cannot continue to enforce and protect our intellectual property rights, our business could be adversely affected” and “Item 1A—Risk Factors—Risks Relating to Our Business—We have been, and may in the future be, subject to claims of intellectual property infringement or tort law violations that could adversely affect our business” included in our Annual Report.

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AOL INC.

PART II. OTHER INFORMATION

ITEM 1A. RISK FACTORS

There have been no material changes to the Company’s risk factors from those disclosed in Part I – Item 1A of our Annual Report for the year ended December 31, 2011.

ITEM 2. UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS

The following is a summary of common shares repurchased by the Company under its stock repurchase program:

Period	Total Number of Shares Purchased		Average Price Paid per Share		Total Number of Shares Purchased as Part of Publicly announced Plans or Programs (a)		Approximate Dollar Value of Shares that May Yet Be Purchased Under the Plans or Programs (a)
April 1, - April 30, 2012		-	$	-		-	$	40,800,000
May 1, - May 31, 2012		-	$	-		-	$	40,800,000
June 1, - June 30, 2012		-	$	-		-	$	40,800,000
Total		-	$	-		-	$	40,800,000

(a) On August 11, 2011 the Company announced that its Board of Directors approved a stock repurchase program effective August 10, 2011, which authorizes the Company to repurchase up to $250 million of its outstanding shares of common stock through August 2012. Repurchases have been and will be made in accordance with applicable securities laws in the open market or in private transactions and may include derivative transactions, or pursuant to any trading plan adopted in accordance with Rule 10b5-1 of the Securities and Exchange Commission. The repurchase program may be suspended or discontinued at any time. The approximate dollar value of shares that may yet be repurchased under the program disclosed above excludes commissions and other fees paid in relation to repurchases through June 30, 2012.

ITEM 6. EXHIBITS

The agreements and other documents filed as exhibits to this report are not intended to provide factual information or other disclosure, other than with respect to the terms of the agreements or other documents themselves, and you should not rely on them for that purpose. In particular, any representations and warranties made by us in these agreements or other documents were made solely within the specific context of the relevant agreement or document and may not describe the actual state of affairs as of the date they were made or at any other time.

See the Exhibit Index immediately following the signature page of this Quarterly Report.

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AOL INC.

SIGNATURES

Pursuant to the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized, on August 1, 2012.

AOL INC.
By	/S/    ARTHUR MINSON
Name:	Arthur Minson
Title:	Chief Operating Officer and Acting Chief Financial Officer

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AOL INC.

EXHIBIT INDEX

Exhibit Number	Description
10.1	Stock and Asset Purchase Agreement, by and between AOL Inc. and Microsoft Corporation, dated as of April 5, 2012.**
10.2	Intellectual Property Matters Agreement, between AOL Inc. and Microsoft Corporation, dated as of June 15, 2012.**
10.3	Amended and Restated AOL Inc. 2010 Stock Incentive Plan (incorporated herein by reference to Annex A of the Company’s Definitive Proxy Statement filed with the Securities and Exchange Commission on April 20, 2012 (File No. 001-34419)).*
10.4	Executive Employment Agreement between Curtis Brown and AOL Inc. entered into as of May 9, 2012.*
31.1	Certification of Principal Executive Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.
31.2	Certification of Principal Financial Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.
32.1	Certification of Principal Executive Officer and Principal Financial Officer pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.†
101	Interactive Data Files Pursuant to Rule 405 of Regulation S-T: (i) Consolidated Statements of Comprehensive Income for the three and six months ended June 30, 2012 and 2011, (ii) Consolidated Balance Sheets as of June 30, 2012 and December 31, 2011, (iii) Consolidated Statements of Cash Flows for the six months ended June 30, 2012 and 2011, (iv) Consolidated Statements of Equity for the six months ended June 30, 2012 and 2011 and (v) Notes to Consolidated Financial Statements. ††

* Management contract or compensatory plan or arrangement.

** An application for confidential treatment for selected portions of this agreement has been filed with the Securities and Exchange Commission.

† This certification will not be deemed “filed” for purposes of Section 18 of the Exchange Act (15 U.S.C. 78r), or otherwise subject to the liability of that section. Such certification will not be deemed to be incorporated by reference into any filing under the Securities Act or Exchange Act, except to the extent that the Registrant specifically incorporates it by reference.

†† In accordance with Rule 406T of Regulation S-T, the information in these exhibits is furnished and deemed not filed or a part of a registration statement or prospectus for purposes of Sections 11 or 12 of the Securities Act of 1933, is deemed not filed for purposes of Section 18 of the Exchange Act of 1934, and otherwise is not subject to liability under these sections and shall not be incorporated by reference into any registration statement or other document filed under the Securities Act of 1933, as amended, except as expressly set forth by specific reference in such filing.

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