Call it a reversal of fortune at Internet speed. Just a year ago, AOL Time Warner's (AOL ) online arm was on top of the world. It had 27 million subscribers worldwide, its ad revenues were growing smartly, and the just-completed merger of AOL and Time Warner seemed likely to shelter the world's leading online service from the forces that were eviscerating other dot-coms.
Fast-forward to today, and AOL is stumbling. In the fourth quarter of 2001, it added 1.1 million new U.S. subscribers, 8% fewer than the 1.2 million it gained in same period in 2000. Advertising and commerce revenues tumbled 7%, to $637 million, from $686 million a year earlier. And Bob Pittman, the company's co-chief operating officer, has warned investors not to expect any growth in the AOL service's ad revenues for 2002.
No one is watching these travails with keener interest and more glee than Microsoft (MSFT ), AOL's archenemy. Bill Gates & Co. hopes that the rising pressure on the AOL service to shore up cash flow and deliver earnings for its parent company will slow AOL's momentum -- and give Microsoft an opening to steal market share.
AOL recognizes the threat. On Jan. 22, it sued Microsoft, alleging anticompetitive behavior toward Netscape, a rival producer of Web-browsing software owned by AOL Time Warner. As much as a fight over the browser market, analysts regard the suit as a shot across the bow -- an effort to keep Microsoft's ambitions in check.
The stakes are high indeed. AOL regularly pitches to its huge subscriber base everything from magazine subscriptions and books to movie tickets and CDs. It needs to maintain the loyalty of this group -- and keep adding subscribers -- for the synergy envisioned in the AOL Time Warner merger to materialize. Microsoft is after the same customers, most of whom already use its Windows operating system on their PCs.
The software king's new .Net (pronounced dot-net) initiative aims to capture every segment of the Web business, from the software and servers that host Web sites to the Web browsers, billing software, and even the Internet service provider customers who form the core of both AOL and MSN, Microsoft's competing online service. As consumers increasingly shop, listen to music, and watch movies online, Microsoft wants a piece of the action.
Despite repeated assaults from Microsoft, AOL has remained the runaway leader online. It has 26 million U.S. subscribers, vs. MSN's 7.7 million. But AOL's momentum has begun to flag ever so slightly just as Microsoft is picking up speed.
The two companies calculate their customer totals differently, so it's hard to tell exactly how much the gap is narrowing. Bob Visse, MSN's director of marketing, says he added 1.2 million new customers in last year's fourth quarter. But he concedes that 300,000 of those pay for something other than Net access, such as extra storage on Microsoft's Hotmail service -- which costs just $19.95 a year, vs. $263.40 for a year of full MSN service.
An AOL spokeswoman says that if AOL follows Microsoft's model and includes customers who subscribe to CompuServe or to other of its Web services, its fourth-quarter gain would have been higher than 1.1 million. But she declines to say how high.
Visse counters with the assertion that "we are a service for more advanced Internet users, a sort of graduate service from AOL. Those users are more valuable because they spend more time and money online." However, he offers no proof, since he declines to reveal how much people spend on MSN.
That raises the question: Can Microsoft catch AOL? Not right away. Analysts project MSN and AOL will each add about 3 million U.S. subscribers in 2002 -- bringing them to 10 million and 29 million, respectively. As Microsoft mounts a major offensive to dominate the next generation of Web-based services, it's making determined pushes into broadband and e-commerce, arenas it sees as soft targets. "The battle rages on, and Microsoft is gaining slowly but steadily against AOL every day," says David Smith, an analyst at research and advisory firm Gartner.
Microsoft's first priority is broadband -- or Net access speeds of at least 128 kilobits per second for the average Web surfer. Broadband is important both as a platform for the software king's new services and as a tactical maneuver against AOL.
Here's why: Although AOL Time Warner executives insist that high-speed access is the key to their own long-term strategy, the company faces an intrinsic conundrum (see BW Online, 1/4/02, "How Broadband Could Slow Down AOL"). Converting dial-up users to broadband could reduce the fat margins it has come to expect from its AOL unit -- margins that are especially important with the ad market in a slump.
Over the past two years, AOL has nearly doubled its margins before interest, taxes, depreciation, and amortization (EBITDA), to 37% in the second quarter of 2001 from 19% in the first quarter of 1999. In large part, the increase reflected the plummeting cost of dial-up equipment and data-transfer services, which have fallen 69% in just 30 months. According to Michael Gallant, an analyst with CIBC World Markets, such network savings accounted for at least 40% of the division's EBITDA growth over the past three years.
AOL may need to push harder overseas to keep subscriber rolls on track
As the online market matures and AOL is no longer able to sign up as many dial-up subscribers, it will be almost impossible for AOL to continue to boost margins in this manner. CIBC predicts the U.S. will have 14 million new dial-up users over the next three years. That means AOL will either have to increase its market share or add millions of new overseas subscribers each year just to match the 6.5 million new customers it added in 2001.
Even if tech costs fell an additional 70% over that period -- an unlikely prospect -- Gallant estimates that AOL's margins would increase only 6 points, vs. the 18 points it has realized over the past two years. Under those circumstances, AOL may not want to risk damage to its dial-up business by pushing subscribers too quickly to broadband. CIBC figures that margins on such customers could fall to as low as 9% on high-speed networks other than the house brand, Time Warner Cable.
CHINKS IN THE ARMOR.
Microsoft's advantage under this scenario is that its MSN dial-up business never achieved AOL's rapid growth -- or profits. "MSN isn't stuck in a huge legacy dial-up business," says Gallant. "It will move full-steam ahead, whereas AOL wants to see broadband penetration happen more gradually." An AOL spokeswoman declines to comment on Gallant's projections, but she suggests that new advertising and commerce revenues would make the economics of broadband compelling for AOL.
Microsoft also sees another chink in AOL's armor: the business of helping Web visitors establish online identities. Microsoft's Passport service, which allows consumers to use one name and password for access to multiple Web sites, could put the Redmond (Wash.) company at the center of most online transactions. As AOL had in dial-up service, Microsoft has a huge head start here.
Microsoft claims that about 200 million Netizens already have a Passport account and that the service authenticates 3.5 billion transactions at more than 100 partner sites each month. Liberty Alliance, a rival identity service backed by Sun Microsystems and AOL, hasn't yet released a competing product, though it has signed up big-name partners such as American Express. AOL's own identity product, code-named Magic Carpet, also is still in development.
"Passport and Liberty are about bringing together the world of the [corporate] enterprise and the consumer," says Gartner's Smith. "In that game, Microsoft has a colossal advantage." Microsoft's ubiquity in corporate computer systems gives Passport the edge, Smith adds, because it works seamlessly with other Microsoft products, such as servers and the Windows operating system.
Whether consumers will warm to Microsoft's Internet initiatives is another matter, of course. AOL is a well-regarded and trusted consumer brand. Microsoft, by contrast, has suffered bad publicity over security lapses at some of its popular sites, such as Hotmail, plus skepticism regarding its sensitivity to consumers' desires for privacy and good customer service. Still, with $36 billion in the bank, Microsoft has the luxury of taking the long view.
Look no further than Windows for proof of Microsoft's relentlessness
It may have been an also-ran in dial-up service. But look no further than the company's track record with Windows -- the basic software that now runs 91% of the world's PCs -- for proof that it never relents. Microsoft released five versions of Windows before it became in 1992 a mass-market competitor of Apple Computer, the market leader in point-and-click computing at the time.
Another example: For much of the past decade, Microsoft's server software was a running joke in corporate computing circles. But with steady improvements in the product, Microsoft claimed 42% of the market in 2000, according to researcher International Data Corp. That's up from less than 1% in 1992, when it launched its first server software.
Although MSN will continue to lag behind AOL in the number of Internet subscribers, Microsoft may ultimately compete head-to-head with AOL for consumer dollars spent online. "Content is not king, and it never has been," declares Matthew Rosoff, an analyst at consulting firm Directions on Microsoft, referring to AOL Time Warner's top media brands. "Compared with AOL," he adds, "Microsoft has a far superior understanding of how consumers use computing devices," which will help it woo consumers who want more than just dial-up access.
Barring an extended recession or fresh legal troubles, Rosoff predicts that Microsoft by 2005 will collect nearly as much in monthly fees from online consumers as AOL does, for a wider variety of services. "We're a company that has taken one or two or three tries to get things right," says MSN's Visse. "When we do, a lot of customers come our way."
By Jane Black in New York