October 9, 2002 2:21 PM PDT

AOL's broadband headache

America Online has taken a hit from a slump in ad sales--and now Wall Street is waiting for the other shoe to drop.

Declining advertising revenue has been plaguing the Internet unit and its corporate parent AOL Time Warner. Now AOL's bedrock business of selling subscriptions to its online service may be the next area of corrosion, according to Wall Street and industry analysts. The dial-up access market, where AOL dominates, is reaching saturation, and the division is losing subscribers to rival broadband services. AOL has also been slow in upgrading its users to its own broadband service.

However, converting its subscribers to broadband could be a greater headache for the company than dealing with dwindling dial-up customer numbers. Broadband means lower margins for AOL due to the high cost of paying cable and phone companies for their high-speed lines. In the long run, it could mean declining earnings for AOL.

"Because of the steep access fees AOL is required to pay to the cable operator, the economic model for broadband will vary greatly from narrowband," Jessica Reif Cohen, a Merrill Lynch analyst, wrote in an investor note Wednesday. "Indeed, the material economies of scale that narrowband enjoyed are unlikely to be replicated in the broadband world."

Cohen added that this squeezing of margins could cause AOL's subscription earnings before interest, taxes, depreciation and amortization (EBITDA) to drop from $850 million in 2003 to $235 million in 2005. Although these estimates are Merrill Lynch's "worst case" scenario, they shed light on a problem facing many access providers: Steep broadband costs translate into lower margins.

In other words, dial-up may not be so bad after all.

AOL remains the undisputed Internet access leader with 35.1 million subscribers. That's a far cry from Microsoft's MSN, which has more than 8 million for its own ISP (Internet service provider). In July, AOL Time Warner executives said 17.7 million U.S. subscribers pay the full $23.90 a month for AOL, still more than double the number of subscribers of its closest competition.

But ongoing financial woes and a looming Securities and Exchange Commission investigation have continued to trouble AOL and its corporate parent. Last quarter, AOL's advertising and commerce revenue dropped 42 percent from the previous year as a result of the dot-com implosion, but the company reported a 20 percent boost in subscription revenue.

The question in many people's minds now is whether subscriptions will continue to grow at this rate and whether moving subscribers to broadband will strengthen the business.

"If broadband is growing, it's just taking market share away from dial-up," said Paul Kim, an equity analyst at Kaufman Bros. "If AOL owns half of the market for dial-up, you figure it will suffer."

The contradiction about broadband is that it's an asset and a liability for AOL. It wasn't long ago that Wall Street clamored for AOL Time Warner to speed up its migration of users to broadband. Having a high-speed link into the living room could allow providers such as AOL, MSN and Yahoo to sell additional services such as music downloads, online video games and home-networking capabilities.

Nearly a year ago, AOL Time Warner's former chief operating officer, Robert Pittman, pinned the media giant's future on broadband. He claimed that a fast pipe into the home meant AOL could collect up to $159 per month per household, adding together access fees and other services. Combining that with Time Warner Cable's interactive services, Pittman said revenue per household could jump to $230 a month.

Hard realities
But times have changed, and so has AOL Time Warner's management. Pittman resigned in July after coming under enormous criticism inside and outside the company for his management style and for AOL's financial troubles. Before he left, Pittman stepped back from his stance on broadband, stating that AOL's narrowband business offered better profit margins than broadband.

Unfortunately for AOL, consumer appetite is shifting toward a business of lower margins. The number of U.S. households with broadband has jumped from 5.2 million in 2000 to 10.4 million in 2001, and is expected to reach 15.4 million in 2002, according to Jupiter Research. As this number grows, further pressure will be placed on AOL's shoulders to prevent its dial-up subscribers from defecting.

"Broadband is definitely the future, but is it a future that will be profitable for you as an access provider?" said Joe Laszlo, an analyst at Jupiter Research. "It comes down to striking special deals with line providers or if someone can find the magic bullet for value-added services that people will pay for."

"Value-added services," or services that providers can charge an extra fee to use, have yet to take consumers by storm. A year ago, many analysts and industry observers predicted that online music subscriptions would drive broadband growth. But to date, joint music efforts, such as MusicNet and Pressplay, from the recording and Internet industries have yet to convince consumers to open their wallets.

Web giant Yahoo, which has been on a crusade to sell "premium services" throughout its network, has shown some good results. In July, the company said it has 1 million users who pay for services such as e-mail forwarding, personal ads and extra storage, to name a few. But these products have yet to give Yahoo a material boost in its earnings and remain in their growth stages.

AOL is now on its own mission to sell additional services. The company is trying to model itself after paid television networks by offering its users programming and services that cannot be found elsewhere. AOL hopes that exclusivity in the form of new songs or video game prereleases will convince its subscribers to pay an extra few dollars a month. But a few dollars won't help an overall decline in subscription revenue.

"It's going to be woefully inadequate to address subscription revenue going down," Kaufman Bros.' Kim said about premium services. Access subscriptions are "the only way you can make money on the Internet."

 

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