"NO BRAINER">>>>>>>>> Complete America Online Analysis Kevin Prigel
Oct 1 1999
America Online NYSE:AOL
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Industry Analysis
When attempting to define the industry that America
Online participates in, one must look solely at the
America Online business model. AOL is not in an industry;
it is defining an industry. This industry's scope reaches
far beyond the provision of Internet services, or online
content.
America Online, and the online service arena, is a
convergence of old and new media. These media meld
into a "vertical portal" that allows users near
instantaneous access to virtually any item of interest.
This portal also allows users to interact in virtual
community, with means including e-mail, chat, and
message boards.
The industry definitely is not stagnated in provision of
only the predefined services. AOL is now leading the
charge into further convergence of media,
telecommunications, and technology. Only the future will
show how these traditional mediums commingle to form a
new industry; the one thing that is certain is AOL's
position as a leader.
Company Profile
In 1985 Control Video, an online service for Atari
computer games, was rechristened as Quantum
Computer Services, and launched Q-Link Service for
Commodore users. Q-Link was such a hit that Quantum
signed deals with Apple and Tandy to provide online
services in 1987. With continued success, America
Online was launched in 1989 for IBM and Apple
computers.
To fund efforts to defeat Prodigy and Compuserve, AOL
went public in 1992 at a split adjusted price of $0 13/32.
America Online spent heavily to promote their service
stealing market share from Prodigy and Compuserve. The
service added content from Knight Ridder newspapers,
and "Time" magazine. By 1993 America Online focused on
the Windows market, releasing their first version of the
software for Windows 3.0 and blanketing the country
with disks.
The million member milestone was reached in 1994,
making AOL the #2 online service provider (behind
Compuserve). European service was launched in 1995 by
teaming with the Bertelsmann group. That same year,
North American service eclipsed the 2 million member
mark. Flat rate pricing soon became the main selling
point, as America Online began offering all the AOL you
could stand for $19.95 a month in 1996. Network
problems and lawsuits plagued the company as users
took AOL up on their unlimited access offer.
AOL acquired its once gargantuan competitor in 1997, as
it traded its data network to WorldCom for Compuserve
and $175 million in cash. In the first half of 1998, AOL
purchased NetChannel to tap into the interactive TV
market, and Mirabilis, the provider of ICQ service with 11
million worldwide users.
The second half of 1998 brought the announcement of
America Online's largest acquisition ever, as they
purchased Internet pioneer Netscape. The purchase
cost America Online nearly $10 billion in stock, but gives
AOL a consumer platform beyond AOL's traditional
interface, and some of the most advanced commerce
software on the market.
The Investment Thesis
Unparalleled Reach
America Online now counts a desktop reach that
parallels that of Microsoft. Over 19 million households
subscribe to their proprietary service, reaching over 40
million persons. These 19 million households use the
service for an average of 52 mintes a day, a number
that is closing in on television in regards to usage.
America Online's web properties reach over 60 million
people, with AOL.com, Netscape.com, Digital Cities, and
more. ICQ, the chat service acquired last year for $280
million in cash, now boasts over 38 million users without
a dollar spent on marketing. Finally, the company's
Netscape browser is deployed on over 50 million
desktops.
Extending the Reach
America Online is executing on a broad strategy to
leverage its brand beyond the service they grew up on.
This strategy began with the purchase of Netscape last
year. The Netscape acquisition brought America Online
the reach of the Netscape portal, which is a popular
destination for net users at work. Additionally, the
Netscape browser offered America Online a quick way to
deploy its services onto 50 million more desktops.
Netscape's server software has allowed America Online
to create a turnkey commerce solution for businesses
from small to large. Finally, Netscape's engineering
expertise has allowed America Online to create version
5.0 of its software, that will allow the complete AOL
platform to be deployed on innumerable devices.
America Online is also pursuing partnerships to extend its
brand into the broadband category, which will
undoubtedly dominate the future. AOL already has
alliances in place to deploy its service over DSL lines,
which will be installed by the baby bells and CLECs. The
company made a $1.5 billion investment in Hughes to
reach the massive number of users that can not be
reached by land based broadband with satellite service.
Finally, the company is reportedly in talks to deploy its
service on the AtHome/AT&T cable networks. The AOL
5.0 platform provides a natural interface for broadband
users, with all the ease of the America Online interface,
the power of an Internet browser, and AOL Plus, which
automatically integrates high-bandwidth content for
broadband users.
America Online is also moving beyond the traditional idea
of online services with devices such as AOL TV, and AOL
Anywhere. AOL TV, which will initially be deployed to
DirecTV subscribers, and possibly AT&T cable
subscribers, adds the interactive element to television
that has been developed for years. AOL Anywhere allows
the AOL platform of services to be accessed from
devices from palm tops to cell phones.
It is evident that America Online's goal is no less than
complete domination of American's lives.
The Organic Story: Subscriber Growth
America Online has added over 5 million net subscribers
to its online service since April of 1998, thanks in part to
their churn rate (the rate at which customers leave the
service) moving down 8 of the 9 past quarters. AOL
users are also utilizing the service more, with 760 million
messages sent a day (compare that to 500 million for
the US Postal Service), and over 10% more time spent
online per user.
Netscape Netcenter has been revamped to appeal to
business users in the daytime, and consumers at night
to increase its usage around the clock. AOL.com
continues to expand its functionality, now offering
access to AOL mail and the AOL buddy lists. These
services have created a more loyal user base of the
AOL.com portal.
ICQ now hosts over 1 million simultaneous users at its
daily peak, with over 7 million logging on daily. ICQ has
also been expanded to offer its users a complete portal,
with searching, e-mail, news, quotes, and more.
America Online's Instant Messenger, a service that
allows Internet users to access AOL's popular messaging
features, now has over 40 million users. Movie Fone,
acquired by AOL last year, has over 12 million users a
month, and has been expanded to included e-commerce
with the sale of movie tickets on the AOL service.
The Other Internal Positive: Advertising Growth
While usage of the America Online services continues to
grow, the demand for advertising continues to expand
also. This growth in ad sales, and the rates received on
ads sales, has created exponential growth when
combined with the growth of available inventory. This
explosion in ad rates and inventory sold only looks to
continue. America Online's inventory available to
advertisers continues to grow across all properties. The
company also is in the unique position to create
inventory with cobranded content areas like Dr. Koop on
AOL. AOL now has a $1.5 billion backlog, leaving the
company with plenty of profits in the pipeline.
eCommerce Explosion and Shop@AOL
Shoppers on America Online spent $1.8 billion in the
March quarter. Although this represents a high
percentage of AOL users making online purchases, it
does not yet represent a high percentage of purchases
by these users being made online. That means that
shopping on AOL has a lot more growth in store.
Access to the America Online user base is nearly
essential for massive success of e-commerce companies.
With this knowledge, AOL will soon launch Shop@AOL to
allow America Online users to shop at multiple, selected
merchants with one easy checkout process. Merchants
in the Shop@Home service will include Disney, Sony,
Gap, J. Crew, Toys R Us, Office Depot, and many more.
The Benefits of Broadband
With the mass market adoption of broadband, the
potential for America Online only expands. Broad band
will bring more users online, as set top and net access
boxes become a standard. Users will also be online for
longer periods of time, as hopping online becomes as
easy as turning on the television. With the capabilities of
broadband, America Online will also be able to serve rich
content ads, which offer the opportunity to make the
online advertising proposition far more appealing than
any other medium. Finally, e-commerce on a network
with almost real-time reactions promises to lead to fewer
dropped transactions.
Driving Margins Higher
America Online 5.0 will further reduce the cost structure
of America Online's business, as support costs will once
again fall. Marketing dollars continue to fall in both
absolute dollars and percentage of revenue, as the
existing AOL brand images provide all the marketing the
company needs. Content available on both the AOL
service and web sites will no longer be reconstituted for
the AOL service, with the release of AOL 5.0. Finally,
AOL's Compuserve unit now uses the AOL backend,
completely eliminating the seperate development costs.
Erecting Barriers
America Online currently is using its distinct advantage
over other Internet access providers and portals to
erect barriers to competition. With the permeation of
AOL services, the future growth potential, and these
barriers, AOL is a true gorilla (click on the "Gorilla Game"
book cover in the right pane to find out how to spot
gorilla's on your own).
The Vertical Portal
America Online is the vertical portal. Users of the service
have no need to leave AOL owned entities or partners
once they have logged in. This is true both on the
proprietary software side and the Internet site. The
power of this strategy is immense.
First and foremost, AOL has a virtual lock on user's time.
This amounts to 52 minutes a day at current usage
rates, up from 47 minutes in the last quarter of 1998.
Almost 5% of the time an AOL user is awake they are
logged on. During that entire 52 minutes the user is
accessible for advertising in myriad forms. Unlike TV,
cable, and radio which must break programming for ads,
online there is no need to break.
Second, the vertical portal allows advertising to drive ad
revenues along with e-commerce. Unlike sites like CNet,
which lose surfers to ads, AOL can keep the user within
the AOL portal and take a commission from the sale on a
partner site.
AOL keeps users within their offerings. When a
subscriber logs on, they are only presented with America
Online products, ads, and partners. When they open
their web browser AOL.COM is the first site to open.
When they log-off the service, AOL can offer the last
advertisement, attempting to lure them back. A user of
AOL's service readily spends an hour online without ever
being tempted by a non-AOL partner advertisement.
America Online has a power unlike any other portal, that
allows it unparalleled control over the users experience,
and an unmatched offer for advertisers.
Mass of Users
Simply put, no other online service can offer an
advertiser or partner access to over 90 million users who
utilize services incessantly each day. Just as Microsoft
Windows mass adoption precipitated a move towards an
operating system standard, the size of AOL has begun to
do the same. Virtually every computer manufacturer
includes AOL software preloaded on new computers,
members tell members to subscribe (and receive a free
month of service in return), and corporations fight for
coveted places among America Online's top sponsors.
Brand Recognition
America Online at one point consumed half of the 3.5"
disks manufactured in the world in its marketing
campaigns. Their software comes preloaded on nearly
every desktop system sold. Novice users often confuse
the Internet with AOL's service. America Online has 51%
unaided brand recognition, compared to a high of 9% for
other Internet services. No other service has the name
recognition among the mass market that America Online
has.
This brand recognition continues to expand with the
permeation of the AOL brand into everyday life, and the
impending America Online 5.0 marketing push.
Content Agreements
America Online has aggregated more content into its
service than any other portal. Establishing the
relationships that AOL has crafted over the past 6 years
would take a decade to repeat. Moreover, America
Online does not pay a penny for its content. Content
providers desire exposure on AOL so badly that they pay
to provide their services online.
AOL Applications
"Techies" denounce AOL's proprietary software as slow,
cumbersome, and bulky. However, the AOL software
creates an interface that allows everyone, from "techie"
to "newbie," equal access to the net's offerings. New
users find AOL's interface easy to navigate, while
"techies" can use their own browser on top of the AOL
service to do as they choose. This easy to use interface
will only become more popular as technophobes come
online, and broadband becomes more widely deployed,
making some experienced users unsure of what to do
with all that power.
America Online's last two editions of its software have
also drastically reduced the support cost for customers.
Its even friendlier interface and more stable environment
have created a platform suitable for the mass market.
The 5.0 version of America Online's software is be HTML
based, like the typical web browser. The benefits of this
integration will be three fold. First, all content on the
AOL service can be ported to the web and vice-versa
without trouble, greatly lowering development costs.
Next, it will be a natural convergence of the
technologically superior Netscape software and AOL's
offering. Finally, it will allow America Online to easily
adapt its service to set-top boxes that will allow only
HTML content to be viewed.
Investment Summary
There is now no denial that the Internet has, and will
continue to fundamentally change the way consumers
and businesses interact. Optimistic estimates forecast
that online commerce could total over a trillion dollars
worldwide by 2001. The preeminent choice to participate
in this second industrial revolution is America Online. For
2000 and beyond, AOL is the stock to own.
Risks to Buying
Pricing Pressures
Some pundits continue to believe that the America
Online model can be pressured on the basis of price. This
disbelief in the model continues despite the fact that
AOL has never been the low cost leader. AOL's services
are worth a premium, a fact that users recognize.
In recent weeks, some skeptics have speculated that
large service providers, including Microsoft would drop
access fees altogether. These rumors should be put to
bed now that Microsoft has announced that they will
raise access fees.
Furthermore, the Free ISP model does not make
economic sense for the providers of users. Providers will
not make money off of this model, and users will become
frustrated at the degradation of their performance due
to constant marketing. The only Free ISP that could
ever make it is America Online, who can provide their
service over someone else's infrastructure and make
their profits off of marketing.
Lofty Current Valuation
America Online currently trades at over 400 times last
years earnings. While this seem to be a hefty premium to
the market, one must observe the leverage in the
America Online business model that will allow them to
grow free cash flow and earnings at an unheard of rate
for the next decade.
Net Stock Sell Off
Despite the phenomenal performance of Internet stocks
since their debut, and their constant destruction of
expectations, some doubters continue to believe that
we have entered a permanent Internet stock bear
market.
Cable Access
Some analysts fear that the rise of alternative means of
access, especially cable and/or set top boxes could lead
to the demise of America Online. On the contrary, easy
access to the online world would drive flocks of
inexperienced users to the Internet. These users would
seek the easiest access they could find. AOL is that
access.
Network Disruptions
America Online's service reliability has improved markedly
since the service premiered flat rate pricing in 1996.
Nonetheless, customers continue to demand 100%
reliability. AOL has more than doubled the number of
modems online in the past year, and turned its network
over to WorldCom. Both of these moves should continue
to improve reliability while controlling network costs.
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