September 24, 1999
Why AOL Could Be A-OK
By Cintra Scott
AMERICA ONLINE
INVESTORS IN America Online (AOL) this week probably could have used some bug spray. News and rumors about AOL's small, pesky Internet-service rivals seemed to get everybody all itchy and bothered. What does the buzz add up to? We say it's time to stop scratching and look ahead.
Take a step back, and try for a bit of perspective. Clear your mind of the latest market noise. Is talk of "absurd" tech valuations banished from your brain for now? Good. Are whispers of what the Fed will do on Oct. 5 gone, too? OK. You're ready.
Now, where do you see the Dow and S&P 500 a year from now? If your answer is some number higher than their current levels, take a closer look at our screen today. It's specially designed for market optimists who can take a somewhat longer view.
The SmartMoney High-Beta Screen seeks out stocks on the move. In particular, we filtered for stocks that seem to be poised for upward mobility -- based on company growth prospects -- but have been held back by the market's skittishness in the face of interest rate uncertainty and other short-term concerns. Put simply, we're interested in volatile stocks that do better than the overall market when the market's doing well. (They do worse than the overall market when the market's faring poorly, too, so Dow 5000 predictors need not read on.)
AOL fit the bill. This gorilla of the Internet jungle has 18 million Internet service subscribers -- a hefty 20 million when you include its subsidiary, CompuServe. The new three-million-user EarthLink Network (ELNK) will be AOL's closest competitor in the ISP field, once it joins forces with fellow ISP MindSpring Enterprises (MSPG) in early 2000. At Thursday's celebratory press conference announcing the merger, no one even intimated that the EarthLink-MindSpring combo could topple AOL. Instead, the new EarthLink sets its sights on being "the clear alternative to AOL." Now that's respect.
But investors haven't held AOL in the same awe recently. The stock is trading 44% below its 52-week high hit back on April 7, before the summer's interest rate worries began. In fact, as of Friday's close, it is only up 26% so far this year. At this rate, AOL's revenue and profits are growing far faster than its stock price.
While there are many minor concerns drizzling on AOL's parade, Internet analyst Henry Blodget of Merrill Lynch lays the most blame on the perceived threat of free Internet access. After all, AOL received 70% of its $4.8 billion in revenue last year from subscription fees, typically $21.95 per month. And this week the pricing threat loomed large, heightened by Friday's IPO of NetZero (trading under NZRO). The no-frills free ISP, which boasts 1.7-million users, raised approximately $160 million by selling 10-million shares (a 10% stake) for $16 apiece. By the end of its first day, the upstart's market cap was almost $3 billion. (Meanwhile, AOL's is $112 billion.) Investors have also fretted about AOL's prospects for international growth -- especially in the growing British market, where free Web service dominates.
And some folks were whispering this week that Microsoft (MSFT) could threaten AOL's business model. The fear was that Microsoft's MSN Internet service, which now typically charges each of its two-million users $19.95 a month, could afford to lower its rates to steal business from AOL. But there was a big sigh of relief after Microsoft announced on Thursday it would, in fact, jack up rates by $2 per month to $21.95 -- the same price as AOL. That news helped send AOL shares up 11% on Friday.
Even with a conservative outlook on international expansion, AOL's earnings are expected to grow at least 50% per year for the next three to five years. Furthermore, AOL is unique in that vague but powerful promise that comes with dominance. Its army of users -- the largest by far -- can be drawn on for additional revenue streams if management plays its e-cards right (and so far they've done a pretty good job). Without getting too deeply into the hot-button subject of Internet valuations, AOL's stock price looks low. Its price-to-earnings ratio (based on earnings in both this year and the next calendar year) is below its industry's average.
The analysts are drumming AOL loudly now. On Friday, Jim Preissler of PaineWebber reiterated it as his No. 1 pick, with a $215 price target (120% above Friday's close). Merrill's Blodget also predicted today that the stock will rise through the end of the year, brushing aside the free-ISP threat by questioning its economic viability. (This from a guy who has long stood behind Amazon.com (AMZN) without flinching!) Fellow Wall Street Journal All-Star analyst Fred Moran, who recently joined the brokerage Jefferies & Co., reinitiated coverage of AOL on Thursday with a Buy recommendation and a share-price target almost double the current level. Of course, like the others, Moran is a sell-side analyst by trade (yes, they tend to recommend stocks), but he earned The Wall Street Journal's top stock-picker status -- outshining high-profile stars like Blodget and Morgan Stanley Dean Witter's Mary Meeker. His portfolio reeled in 492% returns last year; AOL was his top pick. His stock-picking secret? Concentrating on ISPs. "We made the argument that offering Internet service was more difficult than it seemed, and that the big telephone companies would not be able to price these players out of the business," he told the Journal.
The next challenge for AOL will be seizing the opportunities of broadband Internet access. But as the industry's 800-pound gorilla, AOL is looking hefty and healthy enough to throw its weight around.
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