Part 1
3/30/98 Fortune 68+
1998 WL 2501087
Fortune Magazine
Copyright Time Inc. 1998
Monday, March 30, 1998
Issue: March 30, 1998 Vol. 137 No. 6
Features/Cover Story
The Internet Is Mr. Case's Neighborhood: Techies hate it, but in
cyberspace
America Online is the only brand that counts. Led by a former P&G
marketer
who's more TV Guide than Wired, AOL is transforming itself into a
real--and
profitable--business.
Marc Gunther Reporter Associates Liz Smith, Wilton Woods
See also page 78 of same issue
To understand the power of America Online, talk to Larry Rosen, the
founder of N2K, an online retailer that wants to become the dominant
seller of music on the Internet. Last year, shortly before going public,
Rosen agreed to pay $18 million--nearly twice his company's annual
revenue--to make N2K the exclusive music retailer on AOL. He also sold a
small stake in his company to AOL, at a favorable price. A sweet deal
for the online service? Sure, but Rosen didn't have much negotiating
power. "When you see that 40% of all online traffic is coming through
AOL," Rosen says, "you've got to be there."
Chris Holden learned that lesson the hard way. Holden is the CEO of
Kesmai, a subsidiary of News Corp. and a supplier of interactive
multiplayer games to AOL until last summer, when it was displaced by an
AOL-owned games company. Within weeks 92% fewer people were using
Kesmai's games, and its business all but collapsed. The company is now
suing AOL, alleging antitrust violations. Says Holden: "AOL is clearly
abusing its monopolistic power to squeeze out anyone who competes with
its own games company."
Only in cyberspace could an outfit thought to be in mortal peril just
15 months ago now stand accused of wielding a monopoly--by a company
owned by Rupert Murdoch, no less. America Online's newfound power, its
sky-high stock price, and, yes, its profits represent a remarkable,
unlikely triumph. Headquartered on a suburban strip in Dulles, Va., far
from the techies of Silicon Valley and the media moguls of Manhattan,
AOL has been underestimated for years by competitors, investors, and
pundits alike. They were all dead wrong. AOL has crushed its rivals,
buying CompuServe, beating down Prodigy, fending off challenges from
AT&T and Microsoft, and deftly embracing the World Wide Web. Today AOL
is the only brand that counts in cyberspace, an online Hertz with no
Avis in sight. While most Internet companies are small-time startups
awash in red ink, AOL has become the first new-media company on a grand
scale, more comparable to Newsweek or a cable company like TCI than to
Netscape. In the fiscal year that ended last June, AOL collected
revenues of $1.4 billion; this year they should reach $2.5 billion.
Analysts project profits of $110 million. With CompuServe, AOL captures
about 60% of home use of the Internet, overwhelming the hundreds of big
and small companies competing to take people online. All are now playing
catch- up to AOL, and they're falling further and further behind--a new
Internet user signs up every two seconds, and the majority choose AOL.
Wall Street is swooning. In the past year investors have driven the
stock up from the $30s to $115 per share--well over 100 times earnings.
AOL now has a market capitalization of $13.8 billion, as much as
Washington Post Co., New York Times, and Dow Jones combined. "AOL has
reached mass media status," says analyst Paul Noglows of Hambrecht &
Quist.
With more than 11 million paying subscribers, AOL reaches about as
many homes as cable operators Time Warner or Tele-Communications Inc.,
and it's adding more than 10,000 users a day. AOL has more subscribers
than Time, Newsweek, and U.S. News & World Report combined. On
weeknights during prime time, the number of people logged on to AOL
peaks at around 650,000, putting it in a league with cable networks MTV
and CNN. Most important, users spend an average of 51 minutes a day
plugged into AOL, up from 14 minutes in 1996. According to Nielsen,
those minutes on AOL come at the expense of television: Users say
they're watching less TV. And AOL subscribers aren't techies--they're
regular, slightly upscale folk who happen to own computers, and 52% of
them are women. This audience is AOL's most valuable asset, more
valuable by far than its infrastructure or technology.
For a decade Steve Case, the thoughtful 39-year-old CEO of AOL, has
focused on building that audience. He lost a billion dollars along the
way. Now he's ready to milk his creation for every dollar he can. He's
selling the eyeballs to advertisers, he's charging retailers steep fees
to set up their online stores in his neighborhood, and for good measure
he's asking his subscribers themselves to pay more for the privilege of
hanging out with their 11 million compatriots. Nobody else in cyberspace
has this kind of clout.
Case is a shy and unassuming CEO, a worrier warrior who would never
claim superpower status for AOL. "It's only the second inning," he likes
to say. "And this is a world that can change overnight." He frets,
rightly, that telcos, cable companies, and Microsoft would like to put
him out of business. When he met Sky Dayton, the founder of an upstart
Internet service provider called EarthLink, Case told the 26-year-old,
"I'm not going to let you sneak up on me like we snuck up on CompuServe
and Prodigy."
Case knows that on the Internet, size guarantees nothing. He didn't
simply overtake CompuServe and Prodigy (the creation of the best brains
at CBS, IBM, and Sears); he outsmarted just about every media and
communications giant pursuing the holy grail of interactivity. John
Malone's TCI was going to merge with Ray Smith's Bell Atlantic to build
the information superhighway. Time Warner's Gerald Levin sank millions
into set-top boxes in Orlando. Michael Ovitz brokered a deal between
Howard Stringer and the telcos to do two-way television, MCI and News
Corp. joined forces, and AT&T sold Net access to long-distance customers
for $4.95 a month. And then there was Bill Gates--creating the online
service MSN, launching MSNBC with NBC, investing in cable operator
Comcast, buying WebTV, even hiring pundit Michael Kinsley to take a stab
at the content biz. Whew. What were the odds that from that crowd Steve
Case would emerge as the winner?
Case always thought the odds were pretty good. Even in the late
1980s, when AOL could barely pay its bills, Case's faith never wavered.
"In a little company everybody's got to believe," says Marc Seriff, an
MIT-educated programmer who was AOL's first head of technology. "But
there needs to be somebody who believes no matter what. That was Steve.
Steve believed from the first day that this was going to be a big deal."
Case's own road to the future began inauspiciously. Long before
anyone was talking about E-mail, chat rooms, or the information highway,
Case plugged a telephone cord into the modem of his Kaypro computer and
tried to go online. It wasn't easy--he spent thousands of dollars on the
computer and modem and software, and weeks getting them to work before
he finally logged on to a now-defunct online service called the Source,
all to read some tiny white letters that scrolled across a green screen
at a maddeningly slow pace.
Others would have quit. Case was entranced. "Despite how hard it was
to set up and use, and despite how expensive it was, something magical
was happening," he said. Never mind that the home computer then--this
was 1982--had barely emerged from Steve Jobs' garage. Case recalls
thinking, "The ability to sit at your desk and access information and
connect with people all over the world--how could that not, over time,
be a huge business?"
That story is part of AOL lore by now, but it is worth retelling,
because out of that experience came Steve Case's one Very Big Idea.
Behind AOL's phenomenal success is Case's bedrock belief that the
service must be easy to try and easy to use. Even now it's too
complicated, he says. "the proof is that we have 5,500 people on the
phones talking to users, explaining to them why something we think is
simple is, in fact, something they think is too hard."
This may seem obvious in hindsight, but sophisticated computer users
for years derided AOL as the "Internet on training wheels." Case knew
that the "digerati"--people who see herky-jerky video streaming over the
Internet at two frames per second and say, "Cool"- -are outnumbered by
the rest of us, who say, "Why would I watch this when I can watch TV?"
Case designed AOL for the rest of us. (I've been a member since 1994.
My mother, wife, and 13-year-old daughter--whose own take appears later
in this article--are regular users too.) And it works, just well enough.
AOL is the simplest E-mail you can find. It's news from ABC, the New
York Times, and cybergossip Matt Drudge, as well as sports, weather, and
personal
finance. It's a convenient way to order books or flowers. Pet lovers,
motorcyclists, recovering alcoholics, and Civil War buffs-- they all
have their own hangouts inside AOL. So do the men and women with screen
names like "Lonesum2nt" and "Pleezme" who flock to chat rooms--15,000 of
them on any given night--called The Flirt's Nook, The Hot Tub, and
Married and Cheating. Some retreat to private spaces to have cybersex,
and more than a few have turned their virtual affairs into real ones.
None of this is about cutting-edge technology--it's about finding easy
ways to do online the things we do off-line, like communicate, get
information, shop, socialize, and fall in love.
When you meet Case, you understand why he gets it. He's so, well,
ordinary. Nothing about him says media mogul--he wears polo shirts and
khakis, lunches on turkey sandwiches and Sun Chips, and has the boyish
good looks of an aging fraternity brother. He's brainy, but not in the
"out of the box" way prized by famous techies who launch their careers
with nifty pieces of software or a breakthrough technology. No, Case is
basically a huckster. He started out marketing hair conditioner for
Procter & Gamble and then tested exotic new combinations for Pizza Hut,
only to find that people preferred plain tomato and cheese. Maybe that
explains why AOL is the hold-the-toppings online service.
Soon after AOL went public in 1992, Case and Jan Brandt, AOL's
marketing czar, devised a harder sell than any ever tried by an online
service--sending out software disks by direct mail to millions of
computer owners, offering them free trials of AOL. The tactic had worked
for Brandt in her previous job, where she'd recruited new members to the
My Weekly Reader book club by sending them a free book rather than a
pitch letter. Before long there was nowhere to hide from AOL. "My job,"
says Brandt, "was to give new meaning to the word ubiquity." Pop singer
Sarah McLachlan's best-selling CD, a box of Rice Chex, and an issue of
Reform Judaism magazine delivered AOL software to unsuspecting music
lovers, cereal eaters, and worshipers. Disks turned up with videos at
Blockbuster, with meals served on United Airlines, even with deliveries
of Omaha Steaks. (First someone had to make sure that freezing the disks
wouldn't damage them.) Today Brandt's wall features a couple of framed
disks, captioned WE COME IN PEACE and RESISTANCE IS FUTILE.
Membership soared, from 155,000 at the time of the IPO to 4.6 million
at the start of 1996. But AOL could not handle the hypergrowth, in more
ways than one. For starters critics charged that AOL was wildly
overspending. "Do the first ten years of AOL represent the creation of
an audience or the marketing equivalent of a Ponzi scheme?" asks a TV
executive who deals with the company. The only way AOL could record the
occasional profitable quarter was by treating its enormous marketing
costs as capital expenses, amortizing them first for one year, then for
two. The company was within its rights, but the aggressive accounting
looked like little more than a sleazy way to buttress the bottom line.
Stung by the critics, AOL abandoned the practice and took a whopping
$385 million write-off in October 1996. That wiped out every nickel of
its so-called profits.
Case, who had never run a big company, was also losing control of his
organization. AOL had grown helter-skelter, from a few hundred employees
to many thousands. (Today there are 9,500.) "This place was
entrepreneurial to the point of confusion," says Myer Berlow, a veteran
advertising executive hired in 1995. "Everyone got to do what they
wanted." To his credit, Case knew he needed help. But William Razzouk, a
former Federal Express executive he brought in to run day- to-day
operations, flamed out after just four months on the job.
Worst of all, AOL was failing its customers. In December 1996, AOL
replaced its $2.95-per-hour usage charges with flat-rate pricing, at
$19.95 a month. The results were predictable--customers spent more time
online; systems overloaded; users felt justifiably betrayed, as did
advertisers and content providers who counted on AOL; and regulators
forced the company to offer refunds.
Yet Case, ever the true believer, saw a silver lining in the crisis.
"What was happening, for really the first time, was that we impacted
people's daily lives in a significant way," he recalls. "Suddenly,
almost overnight, we became part of everyday life. That's why there was
this national outrage and tremendous passion and frustration, because
people needed us, and many of them loved us, and we had disappointed
them. It was a coming of age for the medium." Amazingly enough, people
kept signing on--in droves. AOL's competitors still can't quite believe
it. "How many businesses do you know where you can treat your customers
like shit and still grow your market share?" gripes the CEO of a popular
Internet content company.
Still, Wall Street had this funny idea--that the time had come for
AOL to make a profit. "We are just asking," wrote Morgan Stanley analyst
Mary Meeker as she downgraded the stock, "that a company with a $1.6
billion revenue run rate, eight million customers, and a great (in spite
of itself) brand name demonstrate that it can make a little money." Case
needed someone who could finally translate all these customers into a
real business.
He hit the jackpot with his next choice--Bob Pittman. Pittman was a
marketing whiz kid, a boy wonder who quit college to work in radio,
rising to become a twentysomething star programmer at NBC. He then
co-founded MTV and helped create the brilliant "I want my MTV"
advertising campaign that forced reluctant cable operators to carry the
channel.
But after leaving MTV in 1986, Pittman drifted. He produced a cheesy
talk show, ran Time Warner's Six Flags theme parks, and then became CEO
of Century 21, where he built an online service for real estate agents
and made AOL's first million-dollar ad buy. All that was fine, but
Pittman missed the spotlight--friends like Tom Brokaw and David Geffen
couldn't care less about franchising real estate.
So Pittman was thrilled when Case asked him to become president of
AOL. The son of a Mississippi preacher, Pittman had found a new mission.
"This is the next monster business in America," he declared. Now all he
had to do was prove himself right.
In its essence the problem facing AOL was simple. Providing Internet
access, by itself, is a lousy business. Price competition is intense,
and as more people spend more time online--good news, you'd think--costs
soar. Last year, for example, AOL added roughly 2.9 million members, so
it had to invest $700 million in its access network and in customer
service.
Pittman, 44, has attacked costs. "I'm a maniac on spending," he
boasts. Just recently he laid off 500 people from CompuServe and another
200 from AOL Studios, a money-losing content unit, as both were brought
under his control. (That was a setback for Ted Leonsis, AOL's brash
production chief, who loved to talk about competing with Seinfeld. But
Leonsis, like everyone else who has tried, found that creating
compelling new media content isn't easy.) Pittman has also used AOL's
scale to drive hard deals with backbone providers like WorldCom,
gradually pushing AOL's cost of connect time down from 95 cents an hour
to less than 50 cents an hour. Most important, as the AOL brand built
strength, he was able to spend less on marketing. In the past 24 months
AOL's cost of acquiring a new subscriber has dropped from $375 to $90.
But as Case and Pittman knew, cost cutting alone would never make AOL
a consistently profitable business. The key was to leverage AOL's
massive subscriber base for all it was worth. Pittman would have to
squeeze big dollars out of retailers, advertisers, publishers,
programmers, and anyone else looking to reach the millions of eyeballs
on AOL. The question was: How much could he get?
The answer came from a man named Dan Borislow.
Before they met early last year in New York City, Pittman had never
heard of Borislow or his fledgling long-distance company called
Tel-Save. But Borislow, 36, a tough-talking entrepreneur, got Pittman's
attention in a hurry. "I have a $50 million check in my pocket," he
said.
Like Case, Borislow had one big idea. His competitors were planning
to simplify customers' lives by bundling local, long- distance,
cellular, and Internet access on one bill. "Why not no bill?" wondered
Borislow. If Tel-Save could sign up new customers online, bill them
online, and charge their credit cards, he could cut costs dramatically.
"It costs me a dollar to send out a bill, another 35 cents to cash a
check," he says. Marketing online would save money too. "When all is
said and done, we're saving as much as 50% of the cost of doing
business," he said. With AOL's help, he believed, he could underprice
everybody.
Borislow was a Prodigy user, but he took his idea to AOL because it
was bigger--and because it was in trouble. "This company was having the
worst time it would ever have in its life," he said. "It was a perfect
opportunity for us." AOL had discussed alliances with AT&T and Sprint,
but Borislow was ready to roll. "He reminds me of Ted Turner," Pittman
said. "He's a guy who has a vision and is absolutely certain that his
vision is correct." And he was willing to pay cash.
Ultimately Borislow paid $100 million for exclusive access to AOL and
its subscribers for three years. AOL also got warrants in Tel- Save and
a share in the future profits from the long-distance business. Says
David Colburn, AOL's chief negotiator: "The deal said that this is a
real medium that can generate major dollars--that online is a very
special marketplace and that AOL can make money. And it said it at a
time when we were under tremendous fire."
Suddenly Pittman and Case had a business.
A flurry of deals followed. CUC International paid $50 million for
AOL to carry its online discount-shopping service. Preview Travel paid
$32 million to become the service's online travel agent; 1-800- Flowers
bought the flower concession for $25 million; and N2K paid $18 million
to become the sole music retailer. Colburn, a tough- minded lawyer, also
brought in fax services, greeting cards, and classified ads--in most
cases, pitting bidders against one another. Sometimes he made deals with
both sides. After Amazon.com paid $19 million to become the bookseller
on AOL's Website, aol.com, Barnes & Noble agreed to a $40 million deal
to be the exclusive book retailer inside AOL.
It's too early to tell if these multiyear deals will be as good for
its partners as they've been for AOL. The preliminary signs are
positive. N2K beat analysts' estimates with fourth-quarter revenues of
$4.8 million, the bulk of which came through AOL. When the Titanic
soundtrack was promoted on AOL's welcome screen, N2K sold 750 CDs in 20
minutes. Since its December launch, Tel-Save has signed up more than
300,000 customers for long-distance service priced at a rock- bottom 9
cents a minute. In January, AT&T announced a 9-cent plan for its
Internet customers. "This might be the first time ever that somebody
one-fiftieth their size has prompted AT&T to put out a competitive
offer," boasts Borislow. Last Christmas J. Crew offered a 20% discount
to AOL members and sold more clothes online than in all but its New York
City retail store.
"Now," says Pittman, when asked about the commerce business, "the
only question is, How big, how fast?" In February, Intuit agreed to pay
$30 million to sell financial services. Ahead are deals with sellers of
insurance, office supplies, groceries, and most intriguingly, digital
imaging. Once families put pictures in their AOL Photo Album to share
with relatives and friends, switching to another online provider will
seem like a real pain. Insiders say AOL is close to an agreement with
Kodak.
Commerce deals may be clicking, but advertising, long thought of as
the way for Net businesses to reap profits, has proven less lucrative.
When Pittman does win a big account, AOL gets a payoff that can last
years. Brokerage firms like DLJdirect and E*Trade pay nearly $500,000 a
year for space on AOL's bustling Personal Finance channel. When a new
customer opens an account as a result of an ad, AOL gets a slice of all
future commissions. "If you're DLJ or E*Trade," says Berlow, who runs
AOL's 130-person ad sales department, "you're going to pay me on every
single trade, forever."
More often advertisers are taking a wait-and-see approach. With
hundreds of Internet content sites selling almost unlimited ad space,
rates are falling across the Web. The AOL audience, while substantial,
is splintered across thousands of chat rooms and Websites. Not
surprisingly, most leading companies prefer to sell their cars and
sneakers on TV and in print. Those sponsors like Ford, Toyota,
Coca-Cola, and Warner Bros. that do go online say they'd rather invest
in their own Websites than spend money on AOL. "They're only sticking
their toes in the water," laments Berlow. Says Pittman: "These companies
study everything to death. They move incrementally." For months now
Pittman and Berlow have been trying to sign up Procter & Gamble and
PepsiCo. P&G has reportedly come around; an announcement could be made
any day now. PepsiCo, by contrast, has resisted Pittman's best efforts
to negotiate a stadium-type deal that would anoint Pepsi as the
"official soft drink of AOL"--for whatever that's worth.
Pepsi won't pay, but Pittman has found others who will: Microsoft,
CBS, and other online programmers who are desperate for an audience.
He's not really selling them ads. He's selling them promotion of their
content sites, like Slate and CBS Sportsline. In so doing, Pittman has
begun to reverse the "traditional" way of doing online content
deals--when AOL started up, it shared revenues with publishers, who gave
the new service an imprimatur of respectability and invaluable promotion
in the real world. Some major media outlets, like ABC News and MTV,
still get royalties in exchange for valuable TV exposure. Time Warner,
FORTUNE's parent company, gets paid for programming from Warner Bros.
Online and Teen People, as well as other content.
More frequently, though, it's Pittman who's cashing the checks. The
former cable guy has taken a page from the playbook of TCI and John
Malone, who, whenever they can, extract payment and even equity from
programmers who need carriage. Like Malone, Pittman plays hardball. He
booted the Dow Jones Business Center off AOL because Dow wouldn't pay
up. Seeking to build its brand, Bloomberg L.P. stepped in, paying AOL an
undisclosed amount for the right to deliver similar data. Nor does
Pittman play favorites. iVillage--a company partly owned by
AOL--produces Websites for women. But even iVillage pays AOL for
carriage--about $3 million a year. And just to keep iVillage on its
toes, AOL has created Electra, its own wholly owned Website for women.
"It's all about leverage," says Barry Schuler, AOL's equivalent of a
television network programming executive. "Any media company is
leveraging their relationship with their audience. Period. End of
discussion. You build the audience, you figure out how to extract
value.... We have a very big ability to control the flow of our
audience."
Which means that if you don't play by AOL's rules, you're out of
luck. Just ask Kesmai. The News Corp.-owned company creates online games
that can be played by hundreds of people simultaneously. Last year AOL
acquired a competing company, now called WorldPlay, and gave it the
anchor position on its games channel. Others, including Kesmai, were
shoved into the background--destroying their businesses and illegally
limiting consumer choice, Kesmai charges. A trial date for its lawsuit
will be set this month. AOL denies any wrongdoing and points out that
other displaced games companies relocated, with their customers, to the
Web.
Call this the dark side of leverage--the newly disciplined AOL will
try to hit its quarterly profit targets even if that means trampling on
some so-called partners. Many feel exploited. "Pittman wants to build
one brand, and that's AOL," says a disgruntled content provider. "It's
like the networks deciding they aren't going to build Seinfeld or
Melrose Place, but only their own brand." If that's Pittman's strategy,
it's working. Surverys show that AOL's name recognition dwarfs that of
Yahoo, Netscape, or even the Microsoft Network.
The real proof is in the numbers. For the first time in its history,
AOL looks like a company that can generate profits for years to come--"a
New Age blue chip," in the words of Morgan Stanley's Mary Meeker, a bull
once again. For the past two quarters, AOL has reported profits, with no
visible accounting gimmicks. Advertising and commerce revenues totaled
$85 million during the December quarter, up 93% from a year ago. Since
most commerce deals are spread out over time, AOL has $320 million in
guaranteed payments that it has not yet booked as revenues. If Internet
commerce and advertising grow as projected, there's nowhere to go but up
for AOL.
Now the company is applying leverage to its own subscribers. Starting
in April, the price for unlimited access to AOL goes up $2 a month,
meaning most users will pay $21.95. The increase was a clear signal that
at the new AOL, profits matter more than growth. Besides, as analyst
Robert Seidman, publisher of Seidman's Online Insider, predicts: "People
won't leave in droves. Inertia is a very powerful thing." Switching
online services means finding a new provider, loading new software, and
creating a new E-mail address.
So what could stop AOL? One danger is that Case and Pittman try so
hard to please Wall Street that they create legions of dissatisfied
customers. AOL users already endure annoying pop-up advertisements and
screens cluttered with banners. Service remains spotty, occasional
system outages and E-mail glitches seem unavoidable, and members who
call AOL's 800 number for guidance are steered to online help desks
rather than given instant handholding on the phone. No one will ever
accuse AOL of being the Nordstrom's of the Net. |
