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AUGUST 27, 2002 NEWS ANALYSIS AOL: New Execs, Same Old Problems They must shift subscribers to broadband, fend off Microsoft, and cope with declining ad revenues -- and do it all as federal probes widen
Then there's Jimmy de Castro, a former radio exec who heads AOL's interactive services. He was hired this summer by Bob Pittman, AOL Time Warner's chief operating officer and the architect of AOL's phenomenal growth in the late 1990s. In an awkward twist of fate for de Castro, Pittman resigned in July under pressure from the board. Investors reacted positively to the management shakeup but have grown skittish as federal probes have widened. AOL Time Warner's share price climbed to $14 a share on Aug. 22, up from an all-time low of $9.50 in July, only to sink back to $12 as the harsh reality sinks in that the new execs may be badly distracted by the probes. The investigators are looking into the way AOL booked some of its past revenues, its accounting for goodwill, and the timing of stock sales by senior AOL Time Warner brass last year (see BW Online, 7/9/02, "Another Big Charge for AOL?"). The executives cashed out while the company was pushing lofty profit targets -- ones that ultimately weren't met. "SACRED COW." Distractions could be deadly because AOL badly needs a new strategy. What the online service has come up with so far can best be described as a delicate balancing act. It knows it must gradually shift its 26 million U.S. subscribers from telephone-modem hookups to faster broadband connections, but the move has to be made without killing the dial-up cash cow that feeds the bottom line. AOL controls about half of the dial-up Internet market, charging each client $23.90 a month and generating profit margins believed to exceed 40%. "AOL has this sacred cow in the narrowband Internet market," acknowledges Bob Visse, director of Microsoft's rival MSN Internet service. "They make so much money off it." However, America Online's profits are under pressure: Operating income fell 41% in the second quarter, to $473 million, on revenues of $2.2 billion, 22% of AOL Time Warner's total. The main reason is that the growth of the traditional dial-up customer base is sluggish, and the huge capital investments involved in shifting customers to broadband make that business unprofitable for now. At the same time, America Online's advertising revenue plunged 42% in the quarter. Clearly, one way to deal with that huge reversal of fortune is high-speed connections. And AOL is pushing to expand its base of broadband customers from its current total of just 3 million. On Aug. 21, it signed a major deal with AT&T (T ) that will allow AOL to sell broadband services to as many as 10 million AT&T cable customers (soon to become Comcast subscribers once that company completes its acquisition of AT&T's cable systems), as well as Time Warner's own cable subscribers. SOMETHING FOR EVERYONE? AOL isn't pushing the shift to broadband too hard within its existing customer base, however. For one thing, the Comcast deal gives the cable company much of the revenue generated from customers who sign up for AOL Broadband. As a result, AOL's profits in this area will be slimmer -- at least initially. So AOL can't afford to cannibalize its base of dial-up customers too quickly. "We will be following a natural migration in the market to broadband," says AOL Broadband President Lisa Hook. The coming release of AOL 8.0, new software for connecting to the online service, illustrates the tightrope the company is walking. The new release gives broadband users more applications for video, audio, and games than regular dial-up customers. But it also integrates lots of new features for its traditional customers, such as more opportunities to "personalize" their AOL experience by selecting which sources of information and entertainment are placed front-and-center on the screen. For broadband to really take off, AOL badly needs to maximize its advantages by developing richer, higher-quality entertainment content that makes maximum use of new technology. Examples might include an AOL-branded online dating service that includes videos from its paid members or on-demand movie downloads featuring films from AOL Time Warner's New Line Cinema or archived episodes of such hit TV shows as The Sopranos. NO MORE MR. HARSH GUY. The AT&T/Comcast broadband deal will help somewhat because it expands AOL's potential broadband market to as much as 30% of U.S. cable subscribers, more than 20 million homes. Now, it needs to sign deals to gain access to the systems of other cable companies, including Cablevision and Cox Communications. That would augment the broadband services AOL already sells to Baby Bell phone customers over digital subscriber line (DSL) connections. The other big issue facing AOL's new leadership is how to deal with the Internet ad slump. America Online already has stopped dictating harsh terms for long-term ad and content deals and has become much more receptive to its advertisers' needs, according to one ad executive. In some cases, it has also significantly lowered rates to avoid losing business, the exec says. Big problems remain, though. The entire AOL Business Affairs unit, which structured major content and advertising deals under the direction of David Colburn, has been temporarily shut down, and Colburn has left the company under a cloud. And the ad recession is likely to get only worse. Lehman Bros. analyst Holly Becker, in a recent analysis of AOL's top 100 advertisers, figures 40% may represent legacy agreements that probably can be renewed only at much lower rates. CALLING DEFECTORS. Indeed, AOL is hinting that investors shouldn't expect any growth from advertising in the year to come. In the second-quarter earnings report, AOL Time Warner CEO Richard Parsons said AOL's online advertising backlog -- the deals signed but not yet executed -- had shrunk to about $800 million, down from more than $2 billion during the Internet boom. Adding urgency to all this is cash-rich rival Microsoft (MSFT ). It remains a distant No. 2 in the Internet service business, with 8 million subscribers. But AOL isn't dominant in broadband the way it is in dial-up, so that territory remains open. MSN also is growing at a faster rate -- partly because Microsoft has been outspending AOL on many marketing initiatives. In May, MSN began pushing an AOL "defection tool" that makes it easier for customers to switch to MSN. AOL is countering by promising big improvements in its 8.0 software, which is expected to have more features to build AOL communities for chatting and meeting other people. PLAYING DEFENSE. MSN is forcing America Online to respond to its customer-signup drive in other ways, too. AOL is now offering as much as two months of free service to new subscribers and doling out free months to customers who complain about a problem with their service. In response to customer gripes, it also is eliminating some of the annoying pop-up ads that appear on users' front screens. Pulling all this together would be a challenge under any circumstances. Now, with AOL Time Warner CEO Richard Parsons and his Chief Financial Officer Wayne Pace scrambling to prove the company isn't an Enron or WorldCom, the pressure is on to get AOL back on track -- and soon.  By David Shook in New York Edited by Thane Peterson Get BusinessWeek directly on your desktop with our RSS feeds.  Add BusinessWeek news to your Web site with our headline feed. Click to buy an e-print or reprint of a BusinessWeek or BusinessWeek Online story or video. To subscribe online to BusinessWeek magazine, please click here. Learn more, go to the BusinessWeekOnline home page  | | AUGUST |
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