By David Shook Since the earliest days of the Web, America Online has thrived by making it cheap and easy for millions of people to get onto the Internet using a standard phone line. Today, AOL Time Warner (AOL) has 33 million subscribers, 25 million in the U.S. alone. More than half of all domestic households that surf the Net use AOL to get there. Plus, the Goliath of the Internet service provider (ISP) industry has plenty of content to offer subscribers following its $103.5 billion merger in 2001 with Time Warner.
But the salad days may be over -- and a push into broadband and cable access appears to be the company's next big challenge. Speculation is rife that AOL is going to warn investors on Monday, Jan. 7, that it can't deliver on earnings-growth promises it made after the merger with Time Warner. AOL has already lowered its 2001 target from 30% to 20% growth, but many analysts are now predicting the company will drop 2002 earnings growth guidance into single digits during Monday's conference call with analysts.
The reasons go far beyond the economic recession triggered by September 11, the devastating slump in ad revenue, or the internal problems AOL might be encountering in its post-merger era. The No. 1 hurdle AOL faces going forward is a decelerating rate of subscriber growth and an approaching seismic shift in how consumers connect to the Internet at home. Nearly all of AOL's current subscribers still use dial-up narrowband connections -- far too slow to accommodate the growing demand for rich media, such as games, music, movies, and other content that consumers increasingly want from the Web.
ABSOLUTE NEED? This is unfamiliar territory for AOL, which built its hugely profitable dial-up business on open access to phone lines. Now "AOL's huge market share is at stake," says Internet analyst Youssef Squali, of First Albany Corp. The company must expand into the faster-growing broadband Internet sector to fuel growth, and cable is expected to be the largest engine for broadband growth in the U.S. over the next several years.
By 2005, an estimated 50% of U.S. homes will have broadband, with two-thirds of that supplied by cable operators, according to Soundview Technology. The risk is clear: AOL can't be a national player in broadband without across-the-board access to cable. "AOL absolutely needs to have national coverage in cable. That means signed agreements with all the major operators -- from Comcast and Cox to Charter and Cablevision," says Squali.
Most analysts believe AOL can do it, but perhaps not as quickly as Wall Street would like. In recent weeks, most analysts have downgraded the stock -- or at least noted the added risk. The reassessment reflects the fact that AOL holds only 5% of the broadband ISP market in the U.S. right now. AOL's stock is showing the effects: It closed on Jan. 4 below $32 a share, off some 46% from its 52-week high.
SAME IDEA. When it comes to broadband, AOL is hardly the 800-pound gorilla. It's just one of many competitors in a wide-open landscape. Cable providers expect huge profits in the ISP business by virtue of their monopolistic control of their "pipes" into American homes. And every Baby Bell wants a piece of the broadband action through their speedy, high-bandwidth connections called digital subscriber line (DSL). Computer companies and Internet outfits such as Yahoo!, Earthlink, and mighty software giant Microsoft all look to broadband for their future growth in the consumer Internet industry as well.
Only a few hundred thousand existing AOL subscribers pay for AOL Broadband, a high-speed service powered by a cable modem or DSL line. And unlike phone lines, which are available to anybody who wants to use them, cable pipes by law are still controlled by the companies that own them. AOL must strike deals with these companies to secure its future earnings growth.
Cable companies don't exactly have an urgent incentive to strike deals with AOL. Such agreements could give AOL free rein to sign up new broadband subscribers using the cable provider's own pipes. In return, AOL would send back what amounts to rental fees to the cable monopoly, while keeping a fairly sizable profit margin for itself.
WHY SHARE? AOL holds one ace card: Access to Time Warner Cable, which controls 20% of the U.S. cable market -- about 13 million homes. Also beneficial are deals with phone companies to sell AOL service over DSL lines. But to power subscriber and earnings growth, AOL needs access to the other 80% of the cable market it doesn't own.
These cable companies already are offering their own nascent brand of high-bandwidth Internet services. Why should they share their pipes and give AOL the chance to cannibalize their own markets? AOL insists that it can generate enough revenue for the cable companies to make it worth their while by taking over customer service.
Scott Cleland, CEO of researcher Precursor Group in Washington, D.C., notes that many cable monopolies have pledged to open their pipes to avert regulatory pressure from the Federal Communications Commission. After all, Time Warner was forced to open its cables to competing ISPs last year to gain federal approval for its merger with AOL.
PALTRY MARGINS. "It's unlikely that the FCC will push the cable companies into open access against their will, but the industry doesn't want to take that chance," says Cleland. "Cable companies are likely to open their systems in a limited and controlled fashion." The industry still hasn't said when it'll open up to competitors. And it almost certainly will open them to companies beyond AOL.
Why not simply offer AOL's software to people who already have a broadband connection through their cable or DSL provider? That's something AOL does now for $15 a month, on top of whatever broadband access fee the user pays to the cable or phone company. But the profit margins on this arrangement aren't nearly as lucrative as AOL gets with its own broadband subscribers. AOL needs soup-to-nuts deals with the cable providers -- the same kind of unfettered access to customers that it has in the dial-up phone business, most analysts believe.
If AOL can charge $50-plus per month for each new cable-broadband subscriber -- controlling not just the sign-on screen when consumers log on, but the customer service, billing, and technology support, it could continue to build upon its current dominance in the consumer Internet market. But that's quite a premium compared with the $24.99-per-month it now charges dial-up users.
EARNINGS SLOWDOWN. The clock is ticking for AOL. In the fourth quarter of 2001, it added roughly 1.9 million new members -- 200,000 fewer than analysts had anticipated and 400,000 less than the fourth quarter of 2000. In 2002, decelerating subscriber growth should take a greater toll. Analysts expect AOL to sign 6.2 million new members for the year -- slightly less than the 6.3 million total collected in 2001.
That translates into a slowdown in earnings growth for the parent company. Morgan Stanley expects AOL Time Warner to have earnings before interest, taxes, depreciation and amortization (EBITDA) of about $9.9 billion in 2001 before merger costs and $10.4 billion this year. The slowdown is largely due to America Online's fading subscriber growth and to the continued weakness in the advertising market that affects not only AOL but also Time Warner's magazines and cable-TV networks.
And Microsoft is lurking. Its new Windows XP operating software has loads of easy-to-use music and gaming features for Internet users. "It's extremely significant that a year after the merger of AOL and Time Warner, AOL has not secured a broadband deal with another cable company," says Cleland, alluding to Microsoft's own dealings with those companies. Microsoft, he points outs, has staked $5 billion in the proposed merger of Comcast and AT&T Broadband -- a sign that the colossus of Redmond is jockeying to become the preferred ISP for AT&T Comcast's 22 million cable subscribers (see BW Online, 12/21/01, "AT&T-Comcast's Big Winner: Microsoft").
"TARGET OF CRITICISM." Put it all together, and investors aren't likely to gain much assurance from the company on the broadband front when AOL hosts its conference call. An AOL spokesman says the company is actively seeking open-access deals with all the cable providers, as well as broadband growth from existing DSL and satellite providers. But most analysts think the cable deals would be most important -- if they come at all.
There's no reason to believe AOL has less of a chance to secure deals with cable companies than Microsoft, Yahoo!, or Earthlink. Still, AOL remains the national leader for consumer Internet services, a factor the cable industry can't ignore. Content will count for something. "It's interesting how AOL has become in some respects a proverbial target of criticism in this industry," remarks Scott Kessler, analyst for Standard & Poor's. "People are comfortable with the service and loyal to it. I think too many analysts are underestimating that simple truth."
Savvy investors know history is filled with AOL naysayers who declared the company couldn't move to the next plateau and were then proved dead wrong. It has always been a mistake to write off the world's largest Internet company. But 2002 poses its next big challenge. AOL must prove it can maintain its pole position by signing deals across the entire cable industry while it reciprocates by opening its own Time Warner cable pipes to competitors. If it can't, AOL's paramount position in the consumer Internet business could begin to fade. Shook covers AOL Time Warner for BusinessWeek Online in New York