Will Cable Modems Crush AOL?
By Alec Appelbaum
ACCESS COMPETITORS
IN HIS testimony before Congress earlier this week, Steve Case sounded scared. The chairman and chief executive of America Online (AOL) was trying to convince a cautious Senate committee to force cable companies to open their Internet service to alternative providers like his firm. Without exercising such force, Case warned, Congress might jeopardize the notion of an open Internet.
But the senators didn't rally behind the man who trademarked the phrase "you've got mail," saying they needed more information before acting on the problem. And in the long run that could be a big problem for AOL, MindSpring (MSPG), PSINet (PSIX) and other Internet service providers that are now locked out from offering their customers high-speed Internet access through cable modems. The reason why Case is worried is not immediately obvious: Only 750,000 Americans access the Internet through cable modems, compared to AOL's 17 million members and the millions more who use other ISPs to access the company's recently acquired Netscape sites.
To understand his concern you need to think of the broadband Internet like the Internet itself -- a latent force that can quickly gather momentum and change the balance of power in an entire industry before anyone realizes what's happened. For most communities, the best way to get high-speed Internet access at home is through a cable modem and the bundled technology supplied by either At Home (ATHM) or by Time Warner's (TWX) much smaller RoadRunner service. At Home, which recently purchased Web portal Excite (XCIT), and its cable company backers -- TCI (now part of AT&T (T)), Cox Communications (COX) and Comcast (CMCSK) -- are clearly positioning the At Home service as an AOL killer. The special At Home home page available only to subscribers even looks like a broadband version of AOL, with popular channels and aggregated content from a host of providers.
AOL's market strength has pushed local phone companies to offer digital subscriber lines (DSL), a high-speed access technology that runs over existing phone wires, at affordable prices. After seemingly endless delays, this summer Bell Atlantic (BEL) plans to offer unlimited Internet access through DSL; SBC Communications (SBC) hopes to break out this fall. AOL is putting its weight behind this deployment. The company will buy all the DSL connections its customers want and resell them with the AOL service for around $40 a month. But residential DSL is only available in a few cities, and its technology is hard to send to suburban and rural areas. If cable companies build a significant lead in the delivery of high-speed Net access -- and freeze AOL out of the marketing packages that accompany cable-modem deployment -- AOL could see its growth and margins slow dramatically.
That's because the steepest growth of the Internet in the U.S. -- the market most advertisers care about -- may come at the broadband end of the spectrum. Internet research firm Jupiter Communications forecasts seven million cable-modem subscribers at the end of 2002, a near tenfold increase from today's number. The firm expects DSL to grow to half that size. But whatever technology AOL uses, its membership will surely keep growing: 63% of Americans still haven't gone online. Jupiter analyst Zia Daniell Wigder notes that AOL's core customer base has traditionally been comprised of "newbies," skittish surfers more concerned with friendliness than bandwidth.
Trouble is, those newcomers won't necessarily light up advertisers' eyes. "There is no other provider right now that has momentum equivalent to At Home," argues Michael Harris, president of cable-modem research firm Kinetic Strategies. "AOL can look at those seven million customers as customers they could have had for dial-up broadband." Of course, even if seven million of AOL's 17 million subscribers abandon it for the cable companies' services, you'd still have a market leader. It just might trade at a multiple closer to General Motors' (GM) rather than Yahoo!'s (YHOO).
The slowdown would come, says Gartner Group research director Eric Paulak, because advertisers would divert some of their marketing dollars to chasing affluent customers on high-speed connections. "AOL is very general purpose, but if you can focus on high-speed access, you can target consumers," says Paulak. "We believe that broad enough content at a high speed is better for advertisers than great content at an average speed." This logic feeds itself; cable modems' presence signals a high-end customer while its technology lets advertisers use features like streaming media that most AOL connections can't handle. Then there's an upscale marketing imbalance that Paulak says favors the cable firms; Time Warner can sell its RoadRunner service by offering free HBO for six months, while AOL has just started partnering with tiny Tel-Save (TALK) to sell discount long distance.
So what can AOL do? Waiting for the government's aid appears foolhardy. Harris notes that the Federal Communications Commission's chief priority -- increased local phone competition -- is getting served as AT&T absorbs TCI and AOL pushes Bell Atlantic and Southwestern Bell to improve their DSL reach. Congress probably won't step in unless At Home tries to merge with RoadRunner. Another option is to puff up its brands by revamping its marketing -- something it's quietly tried already. "In a lot of cases you'll find that 20% to 25% of cable-modem subscribers use AOL email for $9.95 a month," says PaineWebber analyst Jim Preissler. For this refocused marketing to steal cable modems' thunder, though, AOL needs to energetically push DSL -- a strategy that could hurt its bottom line.
Since it runs over existing phone lines, DSL seems easier for phone companies to provide. AOL spokesman Tom Ziemba projects 20.2 million homes will be able to use DSL under the AOL reselling arrangement by 2002. But the technology, like regular phone connections, gets costlier when subscribers live further from a service company's central equipment. Paulak estimates that reselling DSL will yield AOL a gross profit per customer of $5 to $10, whereas it now makes $8 to $12 per dial-up customer. Beyond the "management headache" of reselling DSL, Paulak says, the economic prospects facing Case favor a deal with one of the cable firms.
AOL policy spokeswoman Kathy McKiernan is adamant that the firm can collaborate with its cable rivals. "We will make exactly the same technical investments that At Home and RoadRunner are making," she says. Yet most cable companies are already vested with those rivals. Of all the unwed cable companies, Paulak says, over 80% are affiliated with At Home or RoadRunner, leaving "strictly second-tier" players who are too small to eliminate the threat. Since MediaOne (UMG) agreed last month to become part of Comcast, Paulak notes, a major acquisition on AOL's part seems unlikely. More possible, says Preissler, AOL will follow "contingency plans" that focus on aggressive DSL deployment, designed to assure the Street that it's developing a broadband strategy.
"We're very optimistic about broadband," says McKiernan. Perhaps. AOL has always bounced back from near-demise, and it's still an open question whether DSL or cable modems will join Betamax in the technological dustbin. Plus, the company has a growing Latin American business, a new e-commerce alliance with Sun Microsystems (SUNW) and all of Netscape. But the clock is ticking. "Down the road if DSL is going nowhere and cable modems are taking off, we'd really put pressure on AOL to come up with a solution," says Preissler. And if an online visionary like Steve Case is frightened, we want to invest in what scares him.
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