Will Less Be More for AOL?

Time Warner is set to unveil a makeover that will reduce AOL's dependence on subscriber fees and increase its reliance on ad sales

To call AOL a shadow of its former self is an understatement. The company formerly known as America Online, once a goliath among Internet service providers (ISPs), boasting 30 million subscribers, has seen its customer base shrink to less than 19 million since merging with Time Warner in 2001. Now, AOL is poised to shrink further.

To date, efforts to stem the losses—including offering high-speed broadband and doling out discounts—have faltered. More than 800,000 subscribers defected in the first quarter alone (see BusinessWeek.com, 5/4/06, "The Ails of AOL"). Analysts expect a comparable decline when Time Warner (TWX) reports second-quarter earnings on Aug. 2.

That same day, Time Warner plans to announce a series of changes at AOL that analysts say will mark the end of the company's paid-subscriber model. The company will begin relying on advertising sales rather than monthly fees paid by customers, according to the Wall Street Journal. "I don't know whether advertising will work, but my thinking is (the changes) are basically an acceptance of what is happening," says Joseph Bonner, a media and telecommunications analyst at Argus Research. "This is a reflection of reality, that they have to find some other source of revenue."


  Moving to an ad-supported model would mean a serious size reduction for the company in both revenue and staff, at least in the short term. The company generated $8.2 billion in sales last year. About 75% to 80% of that came from $15- and $26-a-month subscriptions, says David Hallerman, a senior analyst at N.Y. research company eMarketer.

Advertising, meanwhile, accounted for $392 million of AOL's revenue last quarter. That's a promising 26% increase from the prior year, but still a fraction of subscriber revenue.

The company's internal forecasts call for cutting subscription sales by about two-thirds, to $1.5 billion, by 2009, according to the Journal. Overall sales will continue to decline though 2008, the paper reported. Time Warner has declined to confirm the report, but analysts suspect AOL will begin offering free e-mail, a model favored by competitors such as Google (GOOG) and Yahoo! (YHOO).


  It will be some time before AOL will be able to make up for the subscriber revenue shortfall through ad sales. So analysts expect cuts in operating costs, including a reduction in staff size. "Their revenues are going to be less, and it's an obvious step that you have to reduce expenses when you purposefully reduce revenue," says Hallerman.

Analysts declined to speculate on just how much cutting AOL would have to do. But it's not a stretch to think the company could eventually dissolve its entire embattled customer-service and retention departments, says Jason Helfstein, an analyst with CIBC World Markets.

AOL has faced a barrage of negative press and legal action over its aggressive customer service department, which had a policy of rewarding employees who "saved" customers calling to cancel. In 2005, the company paid New York State more than $1 million in fines after about 300 people called to complain that they had difficulty canceling their service. This year, a former AOL customer Vincent Ferrari recorded a heated, grueling 21-minute attempt to cancel his account and posted the resulting audio over the Internet.


  Helfstein says AOL could also cut back on its marketing and branding budget, which was needed to fuel subscriptions, and significantly reduce the $1.3 billion spent on network costs in 2005. "Long term it is the right decision, but short term there is a lot of pain," Helfstein says. Hallerman likens it to severing an infected limb. "Is it a good move when a person has to amputate a leg to save his life? No. But better to do that than to die. So, it's a hard thing to do," he says.

If the speculation and news reports prove correct, AOL's changes would be ambitious indeed. But will they go far enough, and is it possible for AOL to regain its past heft? "Will the advertising revenue ever replace dial-up?" says Bonner. "I'm not sure when and if that will ever happen. In the dial-up world, you could be all things to everybody—that worked. Now AOL needs to focus." Adds Helfstein: "The question is: What can AOL do for customers that can convince you to stop using Google or Yahoo as your homepage?"

For starters, it can consider family-friendly search, Helfstein says. AOL has been derided and celebrated alike for policies that booted users for cursing and other offensive behavior. Such standards could be the thing that separates AOL from seemingly riskier sites such as News Corp.'s (NWS) MySpace. "AOL is a good family brand. The reason you use it is because it is a Web site you can trust," says Helfstein.


  Another option for the company is to capitalize on its instant-messaging audience by developing related services that could become profitable venues for advertising. Helfstein estimates that, with the savings related to eliminating subscriptions, the company could have an additional $1 billion to put toward research and development.

AOL also could do more to capitalize on its relationship with Time Warner, says Hallerman. Already the company shows older television shows, such as Welcome Back Kotter, on its online video site. It can use such content to drive traffic and advertising dollars. "One of their strengths going ahead is going to have to be the online video side," Hallerman says. "Video and the desire for it is going to just keep growing online. And, as much as we might hear about a new deal done and new video sites showing up, the industry is still at an early stage. And that early stage gives AOL the potential to capture some more audience that has not been AOL customers."

Then, of course, there's the nuclear option, favored until earlier this year by shareholder Carl Icahn, who had advocated breaking up the company. He failed to gain enough support for the proposal and ultimately was forced to settle for an increase in Time Warner's share buyback program.

For other investors, there's hope in AOL's relationship with Google, which last year bought a 5% stake in AOL for $1 billion (see BusinessWeek.com, 11/11/05, "Has AOL Met Its Match?"). "Those guys aren't stupid," Bonner says. "So that gives me some comfort that advertising will work for AOL."

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