America Online's Subscriber Challenge

With its dial-up customers defecting to rival broadband providers, it will have to make its own high-speed service a must-have -- fast

By David Shook

For four years, America Online routinely added more than a million new subscribers per quarter to its Internet service -- this is net growth, including customers who cancel their accounts. This remarkable expansion enabled the world's largest Internet provider to reach its current level of 35 million "members." And until recently, strong subscriber growth guaranteed America Online robust earnings, thanks in part to the leverage such a large audience gave it in negotiating sweet deals with advertisers and commerce partners.

This winter, however, America Online's subscription growth has hit a wall: In the third quarter, it added only 129,000 net additional subscribers, down from 778,000 and 900,000 in the same periods of 2001 and 2000, respectively. The danger in 2003, some analysts believe, is that the No. 1 online service could actually lose subscribers for the first time -- probably in the third quarter, seasonally the hardest time to hunt for new customers.

That would be a big problem for a business segment that accounts for 83% of America Online's $8.8 billion in annual revenue. The service's other woes -- a preciptious drop in ad sales, which tumbled 43% in 2002 and could decline a further 40% to 50% in 2003 as lucrative contracts expire -- could end up looking mild by comparison.


  These troubles could also harm the stock of parent company AOL Time Warner (AOL ). After hitting a four-year split-adjusted low of $8.70 in July, it rebounded 90% by early December, only to retreat 24% as the problems of the online service -- which provides 19% of the parent company's cash flow (or EBITDA, which is earnings before interest, taxes, depreciation, and amortization) -- began to look more intractable.

America Online's slumping subscription growth reflects a variety of factors: One is inroads made by other Internet service providers, particularly Microsoft's MSN service. The latter, at 9 million customers, is much smaller than AOL but is also growing at a much faster annual rate of 13%. An additional factor is market saturation: With some 67 million U.S. households already hooked to the Net, dial-up access has become a commodity business that nonetheless requires heavy spending to attract new subscribers -- at the expense of margins.

"The cost of acquiring a new subscriber has gone through the roof," says analyst Youssef Squali at First Albany Corp. He explains that getting subscribers to sign up for speedier broadband connections costs substantially more than getting a new dial-up customer.


  Moreover, the once-innovative America Online has come late to the broadband party. So far, the service has ceded much of that lower-margin but rapidly growing business to cable and phone monopolies, whose inherent advantage is a billing relationship with existing customers, plus ownership of the high-speed data networks that deliver broadband.

Certainly, AOL Time Warner is trying to solve these problems. On Dec. 3, it outlined a three-pronged strategy to get America Online back on track. But the plan had better work fast, because the service is shedding 3% to 4% of its customer base each month -- about the norm for ISPs. With so many subscribers already signed up, moreover, it's getting harder to replace lost ones from among the shrinking pool of Americans who don't already have an ISP.

The strategy that AOL hopes will compensate for this calls for creating new forms of online content to keep subscribers in the fold, as well as generating new revenues from premium broadband services. Merrill Lynch analyst Jessica Reif Cohen calls these "HBO-type" services -- a la carte digital-music downloads, video games, proprietary Time Inc. magazine content, and other subscription add-ons that will differentiate America Online from its rivals. The hope is that this will prompt customers to keep their accounts or gravitate toward the service if they aren't already subscribers. The third leg of the plan is further cost-cutting (read job reductions) at America Online.


 While those goals sound simple, achieving them won't be. Goldman Sachs analyst Anthony Noto said in a recent client note that while he believes AOL Time Warner can build creative online businesses and premium services that people will buy, it will take several years before these initiatives have a significant impact on all of the group, with its $40 billion in annual sales, $9 billion in cash flow, and $28 billion in debt.

Noto compares America Online's push into premium services to the recent turnaround at Internet portal Yahoo! (YHOO ), a much smaller company with only $850 million in annual sales. He notes that in the year since Yahoo! announced its strategic transition to subscription services, it has generated $100 million in incremental revenues. Problem is, an additional $100 million would add only one percentage point or so of growth to America Online's revenues.

Noto also doesn't buy the notion that America Online can make itself into a "must-have" service like HBO. Specifically, he's skeptical of the outfit's contention that even if millions of its users eventually migrate to a broadband connection from some other ISP, they will remain loyal to America Online by purchasing its $15 "Bring Your Own Access" service. For this reduced but still substantial monthly fee, subscribers get access to America Online's "walled garden" of e-mail and other features via a rival broadband provider.

Already, an estimated 9% of its customers use the $15 service -- which has been available for a few years now, though not heavily marketed, according to Merrill Lynch. But broadband by itself costs about $45 a month, and analysts question how many America Online subscribers will pay the extra $15 rather than dump the service and find their e-mail and news elsewhere on the Web.


  There's also concern that in the near term, broadband will be as much a dilemma for AOL Time Warner as an opportunity. Merrill Lynch's Reif Cohen estimates that America Online generates $13.04 in cash flow per month from subscribers who currently pay $23.90 a month for a dial-up connection. But because its communications costs will be higher for providing broadband service, Reif Cohen estimates that it will realize only $9.66 per month in cash flow from broadband subscribers who pay $45 a month.

Without incremental revenue from new broadband applications, America Online's cash flow (EBITDA) from subscriptions would decline from $2.3 billion in 2001, to $850 million in 2003, to $235 million in 2005, Reif Cohen estimates, as more of its customers switch to high-speed Net access. That's why it's so important for AOL to start delivering compelling broadband services that visitors will pay for. So far, it has delivered none.

The third piece of AOL Time Warner's strategy -- cost-cutting -- will have a more immediate impact on the online unit's bottom line. AOL Time Warner Chief Financial Officer Wayne Pace says the service will focus on profitable subscribers rather than free-trial subscriptions that wind up generating far less income. But the online unit's cash flows, or EBITDA, are still expected to slide 15% to 25% in 2003, to about $1.5 billion -- a decline analysts say the business can make up for with job cuts.


  AOL Time Warner says it plans to review all divisions of America Online for cost savings that it expects to total at least $100 million annually. Analysts have speculated that the outfit could eliminate 1,000 to 2,000 noncustomer-service jobs, or 6% to 11% of its total workforce, in 2003.

While that would help offset much of next year's earnings shortfall, it woudn't address the issue of lackluster subscriber growth. Thus, the group's stock could continue to suffer despite the strong showing of the old Time Warner assets, which Reif Cohen notes "performed at a robust level" in 2002, a weak year for media outfits.

Mark Schultz, co-portfolio manager of the Vision Large Cap Core Fund, still holds AOL Time Warner but sees the online unit as a major point of weakness for the giant. That isn't likely to change until America Online figures out how to once again bring millions of subscribers into the fold.

Shook covers the markets for BusinessWeek Online. Follow Street Wise every day, only on BusinessWeek Online

Before it's here, it's on the Bloomberg Terminal.