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STREET WISE By Amey Stone January 6, 2000 How Long Will AOL Be the Net's Bluest Chip? Doubters say free ISPs could send its stock reeling, while fans think the giant is too smart and nimble to fall far. Here are the arguments. What do you believe? It's hard for investors to get a handle on any Internet stock, following the huge runup in the sector late last year and the volatile price swings early this year. But America Online (AOL), the Net's bluest chip, seems particularly difficult to fathom right now. At the forefront of many investors' concerns is the spread of free Internet access in the U.S. If that were to really catch on, it could jeopardize AOL's subscription revenues -- nearly $1 billion of its $1.5 billion in sales in its fiscal first quarter, ended last Sept. 30. A serious enough hit to revenues would put the profitable company (it had $184 million in net income last quarter) back into the red. January has already spooked investors, with the announcement of two new free high-speed DSL (digital subscriber line) services. To AOL fans, however, Internet access is just one, less and less significant segment of the company's business. Rather than worry about access revenues, they point to AOL's 20 million loyal subscribers worldwide (which amount to an estimated 60% of the total online audience in the U.S.), its valuable Web brands such as Netscape Netcenter, Digital City, and ICQ, and its promising "AOL Anywhere" strategy to reach customers via phone, TV, and other electronic devices. On Jan. 5, the company announced deals with Compaq Computer, Casio, and Hewlett-Packard to make e-mail available on handheld computers. (It announced a similar deal with 3Com, maker of the PalmPilot, last summer.) Wall Street by and large still loves America Online. Analysts have a consensus price target of 101 and most have a strong buy recommendation, according to First Call Corp. "AOL remains at the top of our buy list," Robertson Stephens analyst Michael Graham wrote recently. "We feel very comfortable paying less than $200 billion for a leading brand with 50% market share in the fastest-growing industry of all time." The company has also made it onto several lists of stocks recommended for 2000, including those of Donaldson, Lufkin & Jenrette, Merrill Lynch, and Steve Harmon, chief executive of Internet investment firm e-harmon.com. AVOIDING THE STOCK. Nonetheless, several of last year's most successful and aggressive mutual-fund managers, including Ryan Jacob of the Jacob Internet Fund, Drew Cupps of Strong Enterprise Fund, and Chris Bonavico of Transamerica Premier Aggressive Growth Fund, say they are avoiding the stock. Although they respect the company, they have concerns over how AOL would be valued in a free ISP environment and say they can find better investing opportunities elsewhere. Even while recommending the stock, Merrill Lynch analyst Henry Blodget has said he expects the business-to-consumer Internet group to trail business-to-business names and thinks there will be a correction in the Internet sector this quarter, particularly in b-to-c players. Indeed, most of the recent activity in AOL's stock has been on the selling side. AOL shares have fallen from a high of 96 in mid-December to 74 7/16 on Jan. 5, down 2 9/16 that day. And with a price-to-earnings ratio of 220 and a market cap of $165 billion, AOL isn't cheap and could fall a lot if Wall Street turns negative. There is widespread agreement that AOL is a strong company with several huge Web audiences, a laser-like focus on pleasing the consumer, and excellent management. For now, however, investors have to decide if the risks of owning AOL outweigh the potential rewards. Which side are you on? Here are the opposing arguments -- on issues such as AOL's Internet access business, its AOL Anywhere strategy, the competition, and its valuation. Internet Access Doubters say that free Internet service providers are a huge threat to AOL's stock. The majority of AOL's revenues come from subscription fees, and a big part of its market cap comes from its dramatic revenue growth (up 47% year over year for the last reported quarter). But how many visitors will continue to pay AOL $21.95 a month when free services are available? Even if AOL holds onto its members, detractors contend, many will probably convert to a $9.95 plan for subscribers who get their access elsewhere. AOL also faces a threat on the high end, since it still hasn't inked a deal with a broadband cable provider. Meanwhile, Internet penetration rates are slowing, so that AOL's revenues can't continue to grow as fast in the future, even if it keeps adding customers. Bottom line, say the naysayers: AOL would be better off without its ISP business. Believers in AOL have a different view: that free ISPs are nonstarters. The freebies lack a viable business model, this line of thinking goes, and infringe on the privacy of their customers by collecting and selling information on them. Even if they attract some customers, these will be low-end (read least-profitable) bargain hunters. Finally, say its supporters, AOL could always crush free ISPs if it wanted by giving away its service. That would increase its market share and advertising revenue. More important, if you believe in AOL, is that its loyal customers continue to pay a premium for its service -- not just for Internet access, but for the content and community tools that are central also to AOL's success. AOL is much more than a dial-up service, says William E. Whyman, an analyst at Legg Mason's Precursor Group. He believes that it will only become more central to the lives of its customers as it implements its "AOL Anywhere" strategy. AOL Anywhere Doubters say that the PC will continue to be the primary way people reach the Internet and that as AOL gets into set-top boxes and handheld devices, it will increasingly go head-to-head with Microsoft, a fierce competitor. Yahoo! and Excite@Home will also try to infringe on AOL's dominance. Plus, hundreds of Web sites are scrambling to hook up with wireless devices, which means lots of competition for AOL. Believers say that AOL has the audience reach -- its 60% of Net users -- to lead a transition away from a PC-centric world. Customers will become even more tied to the service when they start using the new Internet appliances. And AOL should ultimately be able to charge higher subscription fees when it launches AOL TV and other services, believes Graham of Robertson Stephens. Deals, Deals, Deals Doubters say that AOL is spreading itself too thin. Not only is it getting into multiple distribution channels, increasingly it's in the software, hardware, and content businesses. And it's aggressively expanding into foreign markets while it builds multiple brands (including Compuserve and Gateway.net) all at once. It's too much for any one company to take on, goes the doubters' refrain. Believers say that AOL's bold approach makes its stock worth buying now. True, it's taking risks. But it has the management team to make its strategies work. It also has the cash to jump on new trends, take over competitors, and ensure itself a top spot in emerging businesses. "AOL is taking a lot of risks, but those risks generally apply to everyone," says Whyman. "They have as good a shot as anyone of being able to pull it off." Valuation Doubters grant that AOL is doing a lot right but say that the market is already giving it credit for that. Even if it succeeds in all its current initiatives, its huge market cap means that there isn't much upside left. Plus, there's a lot of downside if anything goes wrong. Watch out for lower profit margins if AOL is forced to cut subscription fees because of pressure from other ISPs. Says Bonavico: "Unless there is a significant new development or the stock comes down in price, there are other places with more upside where I'd rather put my capital to work." Believers say that AOL is a bargain -- and that its current stock price doesn't factor in a lot of the potential upside. For example, its dollar volume of e-commerce (money spent by customers, not reaped by AOL) should total $10 billion in 1999, more than the sales of all other e-tailers combined, says Graham. The company's cheerleaders add that its valuation doesn't include future revenues from ICQ, Digital Cities, MapQuest, or from other Web properties it is developing. Meanwhile, its own marketing and telecom costs are declining, which could allow it to lower prices without crimping margins. My Thoughts While Business Week Online -- which is an AOL partner -- doesn't make stock recommendations, I like AOL as a company and as a service, and would be happy to own the stock (which I can't, under Business Week's rules for employees). This may not be the right time to buy, however, since the market currently favors different kinds of Net stocks -- such as ones in the business-to-business or high-speed networking businesses. I think it would make sense to buy AOL once the Web sector corrects, which it inevitably will. Not only will the stock be cheaper, but some money-losing highfliers will get taken out, and that should make investors more appreciative of a large, Internet blue chip such as AOL. Your Thoughts? Which side of the debate do you come down on? Is America Online worth buying now? Or are you getting out before the stock falls more? Send your comments to Amey Stone. Stone is an associate editor at Business Week Online. Catherine Yang in Washington contributed to this column. _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ BACK TO TOP					Amey Stone covers the markets and investing for Business Week Online WEB POINTERS To visit some of the sites mentioned in the story, click here: America Online First Call Robertson Stephens e-harmon.com DLJ Merrill Lynch Strong Funds Transamerica Jacob Internet Fund Legg Mason