Commentary: AOL's Sputtering Online Growth Engine

On Jan. 7, AOL Time Warner (AOL ) CEO-designate Richard D. Parsons broke the bad news: This year, his company will grow at about half the rate originally promised when its $97 billion merger closed a year ago. Because of the ad recession, he said, revenues will rise only 5% to 8%, while cash flow will be up just 8% to 12%. The announcement hardly helped the company's standing on Wall Street. Since the merger closed in January, 2001, AOL Time Warner Inc. stock has fallen 33%, to $32 on Jan. 9.

But the drop in ads for the magazine, TV, and online units is only part of the problem. A deeper worry is the plight of AOL itself. Generating a quarter of the company's revenues and cash flow, the AOL online division is the company's engine for long-term growth. After all, the delivery of Time Warner's content to AOL's 33 million online subscribers via fast Web links was the merger's founding vision. But now, the combination of slowing growth for dial-up subscriptions and the pokey progress of AOL's broadband business could cause that engine to sputter. "I don't see any near-term [growth] catalysts for the company," says Storm Boswick, portfolio manager of a technology fund at J.W. Seligman & Co., which has sold its AOL shares.

After years of heady growth, some subscriber slowdown was inevitable. AOL membership grew by only 24%, to 33 million, last year, compared with a 30% jump in 2000. In the U.S., AOL says it will probably get some 3 million new subscribers in 2002, down from 3.7 million in 2001. And growth will likely continue to shrink as the number of U.S. dial-up users plateaus at about 50 million households over the next five years, according to online researcher Jupiter Media Metrix Inc. That will mean a big dent in cash flow: Along with a soft online ad market, the subscriber stall will cut AOL's cash-flow growth from 76% in 2000 to as low as 18% in 2002, says Anthony Noto, an analyst at Goldman, Sachs & Co.

That's why AOL is counting on broadband. By mid-2002, it plans to launch premium-priced services, such as Web phone calls and HBO-on-demand delivered via a connected set-top box to consumers' TVs. COO Robert W. Pittman has said that someday, AOL could charge subscribers $159 a month for broadband access, multiple users per household, telephony, online music, games and films. "The way we can make this a growth company is if we're constantly inventing these services," he says.

But those plans may be tough to pull off. For starters, simply converting dial-up users to broadband won't dramatically boost cash flow. Sure, AOL charges as much as $54.95 per month for broadband access, vs. the current $23.90 for dial-up service. But AOL's sole cable partner, Time Warner Cable Inc., reaches only 20% of cable households. If it wants to provide broadband services to its customers through other cable companies, AOL will have to pay about $30 a month per user, according to Lehman Brothers Inc. So, even if AOL persuades other cable operators to deliver its service, it will pay them a hefty cut.

It's also far from clear that consumers will bite. AOL's broadband service may already be pricey for many. While AOL has 4.6 million broadband users, only an estimated 10% get their links through AOL. Most buy directly from their phone or cable providers and pay AOL just $23.90. With entertainment budgets per U.S. household currently estimated at $120 a month, AOL's plans "become a harder sell," says Jupiter analyst Joe Laszlo.

What's more, AOL will face stiffer competition in broadband from Microsoft Corp. Its MSN unit also plans to leverage the giant's software strength by offering services such as online banking, games, and music. Broadband "opens up the game again," says Bob Visse, director of MSN Marketing. Indeed, if AOL wants to claim its supposed broadband birthright, it had better get serious. Otherwise, it may get an even colder shoulder from Wall Street--and subscribers.

By Catherine Yang

With Tom Lowry in New York and Jay Greene in Seattle

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