The Strain Of Gain At America Online

In early 1993, Stephen M. Case, chief executive of America Online Inc., took stock and made a fateful decision. With 350,000 subscribers, AOL was less than a third the size of rivals Prodigy Services Co. and CompuServe Inc. Case's conclusion: It was time "to slam down the accelerator," recalls the 37-year-old entrepreneur. AOL flooded the mails with free sign-up software--the first specifically designed for Windows. It wooed brand-name content providers--magazines such as BUSINESS WEEK and TV networks such as ABC--and kept adding new areas every week.

The company says it is now adding subscribers at the astonishing rate of 300,000 a month. At that clip, in the fiscal year ending on June 30, the company will double membership, to 6.4 million, making it far and away the top dog in online services. If that happens, analysts say revenues will nearly triple, to $1.1 billion. That's because, at the same time that membership is swelling, AOL says monthly bills are jumping--from an average of $15 last year to $18.40 now. AOL also expects to begin generating revenue from online advertising and product sales of roughly $25 million this year. Another source of revenue will be transaction fees from home banking, which will be offered to AOL customers through a just completed deal with Intuit Inc., maker of Quicken financial software.

Meanwhile, AOL has launched an all-new Internet service, Global Network Navigator (GNN), and is even generating some corporate sales. Because it has excess capacity on its data network during the daytime, AOL now sells data networking to businesses such as Federal Express. Between that and GNN, AOL expects to bring in an additional $50 million this year. "They're growing like crazy and broadening their revenue mix," says Gary Arlen, president of Arlen Communications Inc., a Bethesda (Md.) market researcher. "But the real question is, can they keep it up?"

Indeed, there are constant signs of growing pains. The service continues to suffer from connection problems because the company hasn't added computers and network connections fast enough. On Sept. 29, the system went down for 3 1/2 hours during its prime Friday-night block because mf a software flaw. On Nov. 14, another software glitch shut off network access.

LUCKY BREAK. Service problems, though less severe than they have been in the past, are annoying members and bumping up the "churn" rate--the number of members who drop the service within a year of signing up. Merrill Lynch & Co. estimates that AOL's churn rate has dropped from 36% to 29% this year. Still, that means that for the company to grow from 4 million customers now to 6.4 million by June, it will have to find 2.4 million new recruits and replace 1.2 million departing ones. The company says its new nationwide high-speed network, called AOLNet, should reduce service outages.

Grabbing a flood of new customers from among the millions of consumers buying home PCs has been pretty easy lately. AOL's year of meteoric growth, 1995, turned out to be a time when most of the company's major competitors were caught flat-footed. "AOL has been benefiting from the problems of others," says Thomas Miller, a consultant for New York-based market researcher FIND/SVP. Prodigy, once the highflier in consumer online services, has been mired in management upheaval as its parents, IBM and Sears, wrangle over its future. And the Microsoft Network--a huge threat to AOL--has gotten off to a slow start, giving Case a substantial break.

But AOL's lucky streak may be ending. Already, the company has lost two high-profile content providers: In April, NBC bolted for the Microsoft Network, saying the software giant's view of the digital future more closely matches the TV network's own interactive plans. Now, Time magazine is negotiating with rival CompuServe, which is dangling a $3.5 million guarantee--six times more than AOL's deal two years ago. "It was the RJR Nabisco deal of the online world," says one Time official close to the deal.

It also shows that the former leader of the online pack, CompuServe, is ready to fight back. The Columbus (Ohio) company, a subsidiary of H&R Block, has announced plans to more than quadruple its marketing budget to win new customers this year. The most direct assault will be a new service for neophyte users--whose numbers make up most of the millions who have put AOL out ahead. Being developed under the code name Project WOW, the new service promises to be even easier to use than AOL and is expected to carry a basic monthly fee of $5 to $10. For dedicated Net surfers, CompuServe will offer an Internet-only service code-named Spryte, based on the Spry Inc. Internet-access service it acquired for $100 million in March. The projected monthly cost: just $4.95 for three hours, with each additional hour costing less than $2.

FAT GUARANTEES. CompuServe will also beef up its core service. The 26-year- old network will get a new interface that is more "user-ergonomic." Company officials also hint that Time isn't the only big-name content provider they'll try to lure with fat guarantees. Like AOL, CompuServe is now willing to rack up short-term losses to gain members. "We're dealing with one competitor that isn't making any money," says CompuServe Executive Vice-President Barry F. Berkov. So "we took a position that rather than maximize profits, we're making incremental investments" to improve the service, he says.

AOL's reaction to the possible loss of Time has been to downplay the magazine's significance online. "If our competition wants to spend big bucks to steal brand names," says Mark L. Walsh, an AOL senior vice-president, "I don't think we're prepared to get into a bidding war."

With good reason. While Case has pushed revenues from $51.9 million to $394.2 million in just three years, he has not generated much in the way of profits--and analysts don't expect AOL to be cash-flow positive until the fourth quarter of fiscal 1996. Charges related to a string of acquisitions and the costs of luring new members to the service produced an operating loss of $19.3 million for the year ended on June 30. Had the company used less aggressive accounting practices, the loss would have been more like $70 million, says AOL's investor-relations chief, Richard E. Hanlon. AOL reported the lower figure because it capitalizes the costs of acquiring new members--about $111.8 million last year--rather than recording them as expenses against current earnings. If AOL were to expense membership-acquisition costs, the $85 million operating profit that Merrill Lynch predicts for 1996 would turn into a $100 million loss, Hanlon says.

While critics--including a huge block of short sellers--say this is questionable accounting, Case says it is perfectly prudent. He points out that other service companies--including rival CompuServe--do the same. He says the two-year amortization period is actually conservative since, according to his own research, the typical AOL customer is likely to stick with the service for 40 months. Most naysayers balk at both figures, noting that AOL has added the bulk of its members over the past two years

So far, the short sellers who predicted that the wheels would spin off Case's growth machine have been humbled. Investors betting against Case have dropped hundreds of millions. With the market placing stratospheric valuations on cyber-startups such as Netscape Communications, AOL has seen its shares skyrocket, to more than $80 from $26 at the start of the year. The shares have split twice since the initial public offering at 11 1/2 in March, 1992, and another two-for-one split is scheduled for Nov. 28. The hot stock is a key to AOL's growth formula because Case uses stock to make acquisitions and to finance expansion.

Nonetheless, the pitfalls are there. If the growth machine sputters, the shorts could have their day. In order to keep moving toward profitability, the company must keep bringing in new customers. Without steady growth, AOL may not be able to cover accumulating amortization charges--now approaching $132.7 million. And a solid membership will be increasingly critical as the company tries to extract more revenue from advertising and product sales, which it expects to double, to $100 million, in fiscal 1997.

BARGAIN FARES. The contest for online customers could get far fiercer, however. In addition to stepped-up efforts by Microsoft and CompuServe, there will be dozens of Internet-access services trying to lure consumers with low monthly fees for cruising the World Wide Web. Competitors include telephone companies that can afford to offer connections at rock-bottom prices. Forrester Research Inc. in Cambridge, Mass., predicts that the Web will steal millions of customers from online services.

That's why Case is keeping his foot on the accelerator. He's plowing millions into a new TV ad campaign and is expanding overseas. In March, AOL announced a 50-50 venture with media giant Bertelsmann to develop online services in Europe that will be launched in Germany and Britain before yearend, with service to France by next year. Case says he's also pursuing deals in Japan, Canada, and Latin America. CompuServe, meanwhile, already has 750,000 subscribers outside the U.S. and plans to add 1 million in 1996. Both companies will face stiff local competition, such as Europe Online, backed by a consortium of powerful publishers.

Meanwhile, AOL will have to deal with growing pains at home as well. Some content providers complain that because of rapid growth, they get scant attention from the AOL technicians whom they rely on to spiff up their online products. "They pay no attention when you need something and are constantly after you to generate more traffic," carps Steve Hodas, director of online services for The Princeton Review. One answer is to give content providers publishing tools by mid-1996 that will let them make changes on their own. That's the way the Microsoft Network operates. But because MSN content providers roll their own, Microsoft gives them a bigger cut of its hourly fees--something AOL content companies will surely demand as well.

Certainly, AOL will have to be nimble to stay ahead of the curve. So far, it has proven that it can coast on an open highway. But the real test is how well it can ride over rough roads. For now, Case is hoping to fly over any online potholes.

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