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The Internet Observer, 11.02.98
DLJ Internet Research
You've Got Scale
It's not being entirely oversimple to say that every person often acts upon
a primary value, one measure of worth he or she prizes above all others. The
list of possible values is of course long, ranging from the seven deadly
ones to the few saintly ones, with most of us embodying something less
extreme. In our business, present value always wars with future value, and
we spend a lot of time refereeing disputes over which is more legitimate. At
every opportunity, we try to raise the fist of the present, even if it's
getting pummeled by the beast of "what if". And in no arena is the fight
more fierce than that occupied by the champion of the Internet world, AOL.
Of late, the futurists are keynoting what they believe online consumers will
value more than anything: speed. The argument goes something like this:
today's telephone connections to the Internet are slow, but new technologies
are coming from cable companies and phone companies (those paragons of
customer focus) that will allow us all to gallop online, ultimately leaving
yesterday's limping service providers (namely AOL) shaking their canes at
departing customers. But wait a minute. That's just a different flavor of
the same Kool-Aid these folks were sipping a couple of years ago, back when
the big, bad Internet, at whatever speed, was going to undermine AOL's
business model. And what happened? AOL became the Internet for the mass
market, and the stock went from $11 to $140. Oops.
So what's stopping AOL from becoming the broadband (i.e. speedy) Internet
online service for the masses? Absolutely nothing, other than an absence of
both broadband infrastructure and a compelling consumer product for the
infant high-speed platforms. But that's just what AOL knows best: how to
create a great online consumer product and then provide access to that
product for millions of consumers. In fact, we believe strongly that
broadband access won't be widely adopted until AOL enters the market with
some collection of cable and phone partners, all of whom will eventually
figure out that it's not speed that matters most, but scale. And AOL defines
scale.
As AOL negotiates with potential broadband partners (and you can feel highly
confident that those talks are taking place), it brings a lot to the table
under the banner of scale, including the most recognized consumer Internet
brand, the most popular combination of content and communications features,
fifteen million loyal customers, a deep understanding of the marketing and
technology complexities of providing a mass market online product, and over
a billion dollars in cash. Not to conjure ghosts from AOL's past , but a
streamlined version of Steve Case's old framework built around the letter C
(which no longer gets altered by wiseacres to include collapse and
catastrophe) captures most simply AOL's primary assets: content, capital,
and customers.
Now, leveraging these assets into a real broadband product is going to take
time, but time is on AOL's side, since no one is close to achieving anything
approaching the necessary scale on even a single metric. In the meantime,
we'd look for AOL to establish new relationships and deepen existing ones
with both cable and telephone companies, with the early aim of just figuring
out what the customer of the future actually wants. AOL is the only company
we've encountered that understands consumer preferences may be altered
somewhat in the new broadband world. New types of content, new pricing
options, and new usage habits are all likely variables (among others) in the
prospective customer value equation, and learning on all these fronts needs
to take place. Just knowing how to focus on and figure out the consumer is a
skill AOL possesses to a greater degree than almost anybody, and potential
partners should be eager to learn from the master.
Does this suggest that a philosophy of incrementalism reigns within AOL that
will prohibit a blockbuster broadband deal over the next several months? Yes
and no. Yes, AOL will take the deliberate approach of any company with its
vast market power to an opportunity that is still very undefined. But no,
AOL will definitely not lack the corporate imagination that would make it
receptive to (if not the progenitor of) big, creative attempts to shape
broadband's destiny. Another thing AOL has always been good at is moving on
parallel tracks.
So let's speculate (and speculation, not prediction, is the watchword) on
what one of those transforming events could look like. In the communications
business, unlike in the entertainment world, the whole idea of convergence
may actually happen. A consumer communications bundle, consisting of long
distance, local, cellular, cable, and Internet access in one convenient
package and billing statement, is the dream of any self-respecting
communications or media giant like AT&T or Time Warner. Why wouldn't one of
those types give a lot to incorporate a branded online service with fifteen
million ready-made subscribers into the bundle, and get the Internet skill
set and knowledge base that every other potential partner lacks?
A deal with AOL in this realm could make the precedent-setting Tel-Save
transaction look pretty dinky, and it would highlight even more brightly a
theme we've been promulgating for a long time: the real value-added in any
medium resides in content. That's right, we're back on the
AOL-as-content-destination train (for starters, see our Observer of
9/11/97), and it's still carrying a deep truth. That is, it's not how
consumers get online that matters, it's what they do when they get there. A
huge and growing segment of the online populace is yelling "I want my AOL"
ever louder, and that chorus will be just as tuneful, if not more so, when
faster access platforms become available. Access providers of whatever
stripe will catch onto this sooner or, at their peril, later.
Like AOL, we think it's way too early to precisely handicap the winning
broadband platform or even whether there will be only one. DSL (Digital
Subscriber Line) technology undoubtedly has its problems: multiple
standards, inconsistent performance, and a legacy of being anything but a
consumer-friendly product. But don't count the phone companies out just yet;
there is still time for those lumbering outfits to execute, which they're
more likely to do as their core business becomes even more threatened by the
emerging bundlers discussed above.
Cable platforms like At Home and Road Runner get much more ink than DSL and
are closer to being viable products (at least for a few hundred thousand
existing subscribers), but they, too, lack many of the elements of a
successful consumer online products company. For instance, the magnitude of
the scaling required to provide service to millions of consumers is
enormous, and these companies aren't close to being able to deal with that
challenge, either in terms of technology skills or customer service. Our bet
is that at least one of them will wind up looking to AOL for help.
Lastly, a word about cable regulation may be useful. Cable providers do not
operate under any mandated "common carrier" regulations like the telephone
companies, which in part allow customers to choose whatever dial-up Internet
online service they prefer. Thus, cable companies can act as both access
provider and content provider for a fee established by the cable company,
regardless of consumer preference. Or the cable company can charge
additional ("premium channel") fees to provide access to third-party
services. There are those who believe this is inherently anti-competitive,
while others reject outright the notion that cable companies should be
forced to share, for free, the benefits of their large infrastructure
investments with other companies. While we never model an outcome that
relies on the federal government acting rationally, we do believe consumer
choice is a compelling market goal with many legislative precedents. And we
find it hard to believe that consumers will want their online information
sources selected for them by the same company that comes to plug in the
access wire. AOL is currently pursuing a regulatory (or, more precisely, a
deregulatory) remedy to this situation, and while it's only one of many
cards in AOL's deck, we think it would be smart to keep watching how it gets
played.
We hope we've at least furthered the argument that speed is less important
than scale when it comes to creating a consumer Internet service. It's not
that speed is undesirable, of course; speed of Internet access is right up
there with speed of observation, speed of travel, and speed of root canal
treatment in the pantheon of things that are better faster. But AOL is
approaching the broadband opportunity as it should, with all deliberate
speed. Within two years, we'll be talking about how AOL reinvented itself
yet again and in the process made broadband Internet access safe for the
masses. And if you're a shareholder when that happens, you'll experience
scale like never before.
=================================================
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