AOL guards vast ISP fortress

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Competition among ISPs is heating up, but it's still AOL's game to lose.

The top dog in online services, America Online's vital stats include 21.4 million U.S. and 4.6 million international subscribers for its AOL and CompuServe brands.

But moving forward, is AOL invincible or vulnerable? To stay on top, it must continue to attract new users. One approach would be to offer the service for free, but AOL says that's not in the cards.

Ultimately, AOL's future viability could hinge on its acquisition of Time Warner, expected later this year. Assuming that happens, AOL's subscriber base, coupled with Time Warner's cable subscribers, will come in handy as AOL seeks to upsell dial-up and cable-TV subscribers to a broadband Internet offering.

AOL reported global ad and commerce revenue of $609 million in its quarter ended June 30, nearly double that of a year earlier. Growing ad and commerce dollars make AOL less reliant on subscriptions; subscriptions accounted for 61% of AOL's $1.9 billion revenue in the recent quarter vs. 68% a year earlier.


AOL by far is the largest single online service provider, with a U.S. subscriber base greater than the combined total of the top four rival paid services and active users of the top five free services. But AOL faces competition from thousands of local ISPs. Free ISPs, despite their underdog reputation, are luring away some users.

AOL's backlog of ad/commerce revenue--deals booked but not yet fulfilled--doubled to $3 billion as of June 30 vs. a year earlier, a harbinger of strong short-term results.

But there are some worrisome matters. There are indications--from marketplace buzz and conclusions of a recent Jupiter Communications portal report--that marketers are going to take a tougher stance in negotiating big deals with portal powers such as AOL. Traditional marketers want results, while many dot-coms no longer have the resources to even consider major deals; drkoop.-

com, which last week announced more layoffs, earlier this year renegotiated its $89 million pact with AOL.

Another worrisome sign: AOL/CompuServe netted just 3.8 million new U.S. subscribers in the year ended June 30 vs. growth of 4.6 million a year earlier. Put another way, the U.S. subscriber base grew 22.9% in the recent year vs. 38.3% a year earlier.


The top paid ISPs, besides leader AOL, are EarthLink, Microsoft Corp.'s MSN, Prodigy Communications and AT&T Corp.'s AT&T WorldNet, according to an August report from consultancy Yankee Group. Top free ISPs based on active users are Juno Online Services; NetZero;, developed by Spinway for Kmart Corp.; AltaVista, developed by 1stUp; and, the report said. Those nine ISPs combined account for about 19 million users.

Offering a free service in the U.S. isn't in the cards for AOL, at least not right now, said Myer Berlow, president of interactive marketing at AOL.

"The free ISP model has got a number of problems with it," Mr. Berlow said.

Free ISPs must spend money to build a service and develop an audience even before they generate revenue from ads, he noted.

AOL charges $21.95 a month, but Mr. Berlow argued that goes a long way in giving AOL "a higher value consumer" that becomes attractive to advertisers.


Holding off on a free service is a smart move for AOL, which recognizes free ISPs can't generate sufficient revenue to be easily profitable, especially in the U.S., said Joe Laszlo, a senior analyst at Jupiter. "If AOL saw a business case where it could make a free ISP work in a two-year time frame, if it thought it could generate enough revenue to cover its costs, I'm sure it would have by now." AOL doesn't see that working yet, he said.

Free ISPs may make more sense in Europe, where ISPs can get a share of the toll charges from telephone companies, Mr. Laszlo said. AOL last summer launched a free ISP, Netscape Online (, in the U.K., but consumers there must pick up the charge for dialing in. In contrast, free ISP customers in the U.S. typically using their unlimited flat-rate local phone service to call.

While AOL's domestic audience growth is decelerating slightly, "we have yet to see a major dent in AOL's subscriber numbers due to free ISPs," Mr. Laszlo said.

In a recent report, Jupiter analyst Dylan Brooks contended that although it's unlikely AOL will offer free service in the U.S., AOL will have to offer a lower-priced service--through recent deals with Wal-Mart Stores or Sears, Roebuck & Co. or under CompuServe or Netcenter brands--to expand its base of subscribers and assure its continued U.S. dominance.


In December, AOL linked with Wal-Mart to launch a co-branded, low-cost Internet service, which was to have debuted this year's first quarter. That hasn't happened yet. Wal-Mart appears to be backing away from that plan to do its own thing, A.G. Edwards & Sons analyst Robert Buchanan suggested last month. An AOL spokeswoman said AOL is "still working with Wal-Mart," but that it's to be determined "exactly what (Wal-Mart) want(s) it to be," which may or may not be a co-branded ISP.

In the meantime, AOL has struck deals for co-branded service with Sears and Target Corp.

"AOL doesn't really need to launch a free service," said Rob Lancaster, a Yankee Group analyst. "They are going after the same people that the free services are," namely, the youth market and Internet newcomers. "They have a very nurturing environment and they really cater to people who are not that tech savvy," Mr. Lancaster said.

He added: "They have a hidden upsell agenda, too. They are bringing people in based on the ease of use. But once people don't really need that functionality anymore, they are going to be able to, fingers crossed, offer them broadband."

Indeed, as dial-up service becomes a commodity, future ISP movers will be those that offer broadband services, such as AT&T and AT&T-backed [email protected]; Prodigy; and, pending close of the acquisition, AOL-Time Warner, according to the Yankee Group report.


AOL's acquisition of Time Warner should prepare it for future growth, pinned on broadband service. In addition to selling broadband to existing customers, AOL could sell its service to Time Warner cable subscribers, also a ready-made target.

Mike Goodman, a Yankee Group analyst, estimates, based on national Internet and AOL user data, that about 3 million of Time Warner's 12.6 million cable subscribers also are AOL subscribers. "Those are potential upsell targets for AOL," he said. AOL is also pushing for ways to sell services to subscribers of rival cable systems, such as the more than 16 million subscribers of No. 1 cable service AT&T Broadband.

Of course, many AOL subscribers--attracted because it was easy, not because they are heavy Web users--probably are poor prospects to jump early into broadband compared to, say, the Web-savvy users of a rival service such as EarthLink.

Ultimately, Jupiter's Mr. Laszlo said, AOL may offer three options: broadband service, high-end dial-up service and a possible free offering, assuming network costs come down and ad revenue goes up.

But "it would very much surprise me if we saw an AOL-branded free service. They would probably use an existing or altogether new brand," he said.

In the meantime, Mr. Laszlo said, "AOL is probably right in letting the NetZeros and the Free I's duke it out for awhile. Only when it can make a strong business case for itself or when it sees its subscriber base be really impacted by the free ISPs, then it would prompt AOL to move away from a reliable revenue source like subscription-based ISP pricing."


Given the profit problem with free service and AOL's lucrative cash flow from paid subscribers, there's little incentive for AOL to offer free service unless competitive pressures--such as a possible free play from MSN--force a response.

AOL has shown a willingness to respond on pricing, as seen when it jumped on the bandwagon last year with hefty rebates for PC buyers who signed up for CompuServe. If AOL ever needs a free service, it may already have the brand: Borrowing the name of the free ISP it offers in the U.K., AOL last November registered a new domain in the U.S.:

Copyright September 2000, Crain Communications Inc.

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