AOL's risky double-dipping strategy
By MSNBC's Barton Crockett
When America Online (NYSE: AOL) reports fourth-quarter earnings Tuesday afternoon, investors will look closely at a line item that increasingly is AOL's primary source of profits - fees from advertisers and online merchants, MSNBC's Barton Crockett reports. They should also look at AOL's balance sheet. In a little-noticed shift, AOL is doubling its reliance on these deals by investing in the companies that it is tapping for hefty marketing fees. It's a risky strategy.
AOL stands to profit handsomely if these fledgling partners take-off. But if AOL bets wrong, and lines up with failing cyber-merchants, or if there is a broad decline in Internet stocks, it could lose two ways - ad fees would evaporate and its investments could go bust.
"If the market starts to come down, there is a double whammy, just like there is a double whammy on the upside," said Abhishek Gami, Internet stock analyst with William Blair & Co. in Chicago.
So far, AOL's investments have been anything but a disaster. At the end of the March quarter, AOL had an investment portfolio totaling $271 million, including $80 million of unrealized gains.
But the deals highlight some of the risks unique to Internet stocks.
David Simons, of Digital Video Investments in New York, figures that two-thirds of the marketing fees that top Internet companies like AOL and Yahoo! rely on for revenue growth come from money-losing Web companies that use stock offerings to fund their hefty marketing costs. If Internet stocks tank, so could their sources of funds for the marketing fees that have propped them up.
An America Online spokeswoman would not discuss any aspect of its investment strategy.
AT LEAST NINE DEALS
But research by MSNBC indicates that in at least nine instances over the past year-and-a-half, America Online has signed multi-million dollar advertising and marketing deals with companies it has also investing in.
The deals run the gamut from telephone company Tel-Save Holdings Inc. and music-seller N2K Inc., to perfume-seller Fragrance Counter, online video store Digital Courier and insurance company Provident American.
Such ties can be attractive. With more than 12 million members, America Online has become a de facto king-maker for online merchants. Getting top placement on AOL can almost guarantee big traffic and hefty sales. And by obtaining an equity interest, AOL gains a second way to profit besides sucking up cash from cash-strapped start-ups.
Preview Travel is an example of the potential for double-dip gains.
In 1994, AOL was an early backer of the online travel agent, which went public in November. Since then, the stock has nearly doubled to near $22, and AOL's 12 percent stake has swelled in value to almost $25 million. Meanwhile, Preview Travel has agreed to pay AOL $32 million over five years to be the online service's exclusive flight booker.
But AOL's deals haven't all worked out as well. Just look at AOL's relationship with Tel-Save. In February of last year the New Hope, Pa.-based reseller of long-distance phone services struck a lucrative, $100 million marketing pact to become AOL's exclusive long-distance phone company for four years.
To ice the partnership, AOL obtained warrants to buy 5 million Tel-Save shares, at $15.50 per share. The deal was later expanded, with AOL obtaining warrants to buy another 7 million shares at $22.50 apiece.
In the March quarter, AOL booked a $5 million gain by exercising some of the warrants. But other gains might be hard to come by, since Tel-Save's stock has since fallen by more than 50 percent to near $12, as management has sought - so far unsuccessfully - to sell the company.
Another disappointment? America Online's relationship with online auction-house Bid.com, formerly known as Internet Liquidators.
In February of last year, AOL paid $1 million for a minority stake in the Toronto-based company, and also obtained rights to buy a controlling 51 percent stake at a later date. In November, Bid.com paid $10 million for a two-year marketing alliance with AOL.
But in February of this year, Bid.com announced that the original deal had unraveled, and that AOL would not take over the company.
Gami said that AOL appeared to sour on the auctioneer's business, finding margins too slim.
AOL isn't new to backing upstart online companies. A now-defunct investment unit of AOL's called Greenhouse Networks reportedly invested more than $50 million in more than 30 start-up companies. While some of these investments, such as content area the Hub, ended up as flops, many were successes, including Preview Travel, women's content area iVillage (in which AOL holds a 15 percent stake) and the popular Motley Fool stock talk site.
But AOL has scaled back financing new content sites in favor of taking stakes in new online merchants that also strike fat marketing deals with the online service. That fits better with AOL's new business focus, in which marketing and e-commerce fees are expected to be the primary driver of profits, while subscription fees basically cover operating costs.
EXPECTED EARNINGS
Investors will get another look at the portfolio Tuesday afternoon, when AOL is expected to report operating earnings per share of 19 cents for the fiscal 1998 fourth quarter ending June 30, up sharply from operating profits of seven cents a share the previous year. That excludes one-time charges from a $287 million acquisition in June of instant messaging service Mirabilis Ltd.
Gami said he was looking for total revenues of $792 million, up 14 percent from the third quarter, as AOL benefits from a $2 per month increase in monthly subscriber charges, and the addition of 800,000 new members to its service. Gami said he expects non-subscriber revenues, including advertising and e-commerce fees, to remain flat from the third quarter at about $119 million. Gami said the leveling-off stems from a move by AOL to slow-down sales of AOL-branded merchandise, including t-shirts, in favor of accepting more advertising from other merchants.
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