• by Gavin O'Malley  @mp_gavin, May 3, 2007

Continuing its transformation from a blemish to a bright spot for Time Warner, AOL helped its parent company post better-than-expected earnings for the first quarter on Wednesday. Remarkably, AOL's ad sales soared 40% year-over-year, thanks largely to its move from a walled-off subscription service to a free, ad-supported Web portal.

AOL's overall revenue fell 25% due to waning subscriptions, but that didn't keep its adjusted operating income before depreciation and amortization, or OIBDA--a key measure of profitability--from rising 27%.

While praising the new ad strategy, Time Warner CEO Richard Parsons said projected ad growth for the year would not match the first-quarter rate.

Until recently, AOL's merger with Time Warner in 2000 was largely seen as one of the worst corporate collaborations in history. But critics have had to reassess the deal in light of the success of AOL's decision last October to drop its subscription model for an ad-supported approach.

Upon the release of Time Warner's earnings, Bear Stearns analyst Spencer Wang made a point of praising the recent performance of AOL, saying that the unit was "moving along" in a research note released Wednesday.

"All of the upside to both revenue and EBITDA [earnings before interest, taxes, depreciation and amortization] was due to a slower than expected decline in subscribers in packages that are available for free or lower prices," Morgan Stanley analyst Benjamin Swinburne said in a research note.

Swinburne cautioned, however: "We believe that this is likely a near-term positive rather than something that will drive long-term value for the company."

Earlier this year, Time Warner's stock enjoyed a much-needed jolt, thanks in part to AOL's ad sales, which rose to nearly $2 billion in fourth-quarter 2006, up 49% year-over-year.

Further strengthening its relationship with display advertisers, AOL last month launched a private-label version of Google AdWords search allowing advertisers to place search ads only within the AOL network.

The so-called AOL Search Marketplace was an expansion of a five-year strategic relationship between Google and AOL struck in December 2005 in which Google powered the contextual search ads found on the AOL service.

The initiative is also meant to give AOL a better shot at getting some of the search ad dollars that have traditionally gone to Google.

Other recent initiatives include the launch of AOL Local Search, which incorporates technology from MapQuest and CityGuide, and an AOL Shopping and Commerce Search, which came from a partnership with comparison shopping site PriceGrabber.com.

Reinvigorated, AOL has been busy assembling a solid team of executive leaders. Earlier this year, it named Nisha Kumar to the position of chief financial officer, reporting to AOL Chairman and CEO Randy Falco. Kumar came to AOL from Time Warner Inc., where she held senior positions in operations and mergers and acquisitions. AOL is also presently on the hunt for a star CMO.

Time Warner, which is also the parent of CNNMoney.com, reported sales of $11.2 billion, corresponding to analysts' forecasts, and up 9% year-over-year.

Merrill Lynch media analyst Jessica Reif Cohen said Wednesday that Time Warner's strong performance supported her conviction that this year is a "comeback year" for profits.

Net income fell 18% to $1.2 billion, or 31 cents a share. After excluding gains from asset sales, profit came in at 22 cents per share, beating Wall Street's expectations of 20 cents a share. Time Warner's OIBDA also beat expectations of $3 billion, rising 19% to $3.1 billion.

Another factor in Time Warner's strong performance--and possibly the foremost reason--was its newly public Time Warner Cable unit, which saw solid increases in subscribers for digital cable, digital phone and high-speed Internet access services. The unit reported revenue of $3.85 billion, up 61% from a year earlier and adjusted OIBDA of $1.31 billion, an increase of 54% year-over-year.

Notably, analysts like UBS's Aryeh Bourkoff continue to speculate over whether AOL might be sold or spun off, though Time Warner says it has no intention of letting go.