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For AOL, Ads Are Still a Minus

By Brian Hindo It was a rah-rah quarter for online advertising, no doubt about that. In April, bellwether Internet publishers such as Yahoo! (YHOO) and the New York Times Digital (NYT) reported better-than-expected earnings for the first quarter, thanks in good measure to an increase in ad sales that they projected would average 12% for the full year (see BW, 5/5/03, "Online Ads Take Off -- Again"). Just about the only laggard, it seemed, was AOL Time Warner (AOL), whose America Online Internet service reported a 42% plunge in ad sales for the quarter.

In a sense, that mammoth decline is misleading, since it primarily reflects the expiration of a remaining $178 million worth of multiyear, monster campaigns with dot-com-era customers such as PurchasePro and -- deals that are all but impossible to replicate in the current economy. Moreover, Don Logan, AOL Time Warner's chairman for media and communications, noted that America Online sold more new ads in the first quarter than a year ago, though he didn't reveal dollar comparisons.

Of course, the other way to look at the situation is by the numbers: The online service's first-quarter ad sales fell to $226 million, from $389 million a year ago. That helped cut America Online's total revenue in the first quarter to $2.2 billion, vs. $2.3 billion a year earlier. Its operating earnings rose 11%, to $194 million -- thanks to cost-cutting and its ability to wring more revenue from existing subscribers.

BAD NEWS TED? The steep ad revenue drop-off almost certainly helps explain the Apr. 29 resignation of Robert Sherman, AOL's president for interactive marketing. Sherman was recruited by former AOL Time Warner CEO Bob Pittman in 2001 to restructure the Internet service's ad-sales team. Though a spokesperson says Sherman's tenure was always intended to be temporary, his departure dramatizes the extent to which the jury is still out on AOL Time Warner's ability to turn around its flagging America Online unit -- a task that must be accomplished before the parent company can return to full health.

That bounceback doesn't seem imminent, judging by the fact that on May 5 Vice-Chairman Ted Turner sold 60 million shares of AOL Time Warner stock -- about half his holdings -- for around $790 million. Turner probably wouldn't have taken that step had he foreseen a quick rebound in the company's fortunes or its stock. AOL closed on May 6 at $13.30, up from its 52-week low of $8.70 but well below its 52-week high of $20.13.

During an Apr. 23 conference call with analysts, Logan predicted that ad sales for the online unit would grow at a "double-digit" clip in 2004. Yet that raises the question: Why can't the most powerful player in the online world, with the most paying subscribers by far, deliver ad sales growth on a par with rivals such as Yahoo, whose first-quarter ad revenue rose by 38%?

"ILL-WILL" BURDEN. One reason, it turns out, is that even though America Online's backlog of big deals is disappearing, it still retains a big backlog of animosity from advertisers and ad agencies that remember its high-handed ways when it ruled the boom-time roost. Agency reps complain that the online service once routinely snubbed small and midsize advertisers in favor of big fish -- a tendency that has come back to haunt America Online and its sales force in leaner times. "They're starting from far behind in this rebound because of all the ill-will they generated during the boom," says one online ad agency executive.

AOL's brass recognizes the problem. "We often didn't return phone calls if the deals were perceived to be small," concedes Lon Otremba, the executive vice-president for strategy and operations at the AOL interactive marketing group. "We burned a lot of bridges."

Worse, some ad buyers say the online giant remains stuck in that mode. "AOL is still full of hubris, relative to its place in the world," complains one Internet agency head. "They still only want to make $1 million deals." Indeed, Otremba says much of the first-quarter ad-sales growth Logan lauded came from deals in the $500,000 to $1 million range. But "we absolutely are going after smaller business, too," he insists.

SOGGY RAINMAN. Another common agency complaint concerns AOL's online technology. Many screens on the service -- including many in the highest-traffic areas -- exist on a 10-year-old, proprietary publishing platform called Rainman, which imposes far more restrictions in terms of size and functionality than screens using the standard HTML Web format.

Rainman has it virtues: It ensures that pages load fast, which is crucial to keeping the audience connected. But the technology also limits the size of many ads or requires them to be created in nonstandard sizes, causing some advertisers who covet flexibility to stay away.

In the late '90s, AOL tried to deal with this problem by converting parts of the service to the Web-standard format used by other AOL Time Warner sites, including Netscape and CompuServe. But after slower page loads squeezed traffic, AOL switched back to Rainman. Otremba says America Online has redesigned many of its Rainman screens to display some of the standard ad sizes endorsed by the Interactive Advertising Bureau industry group -- and that AOL is working to speed up screen times for features such as video.

"TOO LARGE TO IGNORE." Of course, most advertisers ultimately are more interested in results than in having their calls returned promptly. And AOL's paying audience of more than 25 million remains a huge lure. "We buy on AOL and will continue to buy," says Brian McAndrews, president and CEO of aQuantive, which owns online agency Avenue A in Seattle. "They're too large to ignore."

That's one of the reasons Mark May, an analyst at Kaufman Brothers in New York, is optimistic about America Online's prospects. He recalls a similar pattern at Yahoo, which also experienced an ad-revenue decline after its long-term deals dried up in 2001. The difference with AOL, says May, lies in the length of its contracts. Yahoo's average term was one year, vs. two to three years for AOL. "It's a lag effect," says May. "It has taken longer for that to catch up to AOL."

May reaffirmed his buy rating on AOL Time Warner shares after the media powerhouse beat earnings estimates for the first quarter, thanks to better-than-expected results from its cable-TV and film-entertainment units. But May is also optimistic about America Online's chances to get its own ad sales growing again, as the sector strengthens -- even though as much as one-third of AOL's ad revenue comes from paid listings on its Web search engine, which is provided by Google.

CUSTOMER DRAIN. Moreover, May expects the parent company's financial performance to improve markedly in 2003. He sees total revenues climbing about 5%, to $42.8 billion, while earnings before interest, taxes, depreciation, and amortization (EBITDA) rise about 9%, to $9.5 billion. At the same time, he expects AOL Time Warner to cut its total debt by roughly 8%, to $26.2 billion, thanks mainly to the sale of assets such as the Comedy Central cable-TV network, which the company just unloaded on Viacom for $1.23 billion. Thus, May pegs AOL Time Warner's stock at $17 by yearend.

America Online's recovery won't be a slam dunk, obviously. And it may not occur at all unless the Internet unit does a better job of maintaining its subscriber base. AOL's dialup service lost approximately 540,000 customers in the first quarter, though some of them migrated to AOL's more expensive broadband service.

Taking that into account, AOL's net subscriber losses for the first quarter still totaled a steep 289,000, leaving analysts wary of continued leakage, though May says America Online can partly offset that by cutting costs. That puts tremendous pressure on America Online to sign up customers for premium offerings such as its MusicNet digital-tunes service and broadband Net access, for which it charges $45 a month.

MAKING NICE. Otremba notes that America Online now has just under 1 million broadband subscribers -- having added 250,000 in the first quarter alone. He also says numbers have remained steady in high-traffic areas of the site, such as the Welcome Screen and the Autos channel. Moreover, AOL announced on May 5 that Sherman's deputy, Lisa Brown, will serve as his permanent replacement. AOL promises that she'll continue his efforts to make the ad sales group more "regionally focused" and "customer-friendly."

Still, having to apologize both for past arrogance and for a dwindling audience is a tough task for any seller in what's still a buyer's market. With Jane Black in New York

Hindo covers the financial markets for BusinessWeek Online

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