AUGUST 3, 2006

News Analysis

By Catherine Holahan

AOL Casts Its Fate With Ads

The ailing unit of Time Warner thinks it can take on Google and Yahoo! in the game they play best—Internet advertising

Time Warner (TWX ) ended an era on Aug. 2 when it formally announced plans to move AOL, once the titan of Internet service providers, out of the business of Internet account subscriptions and firmly into the advertising arena. Whether the move will finally put an end to AOL's woes, however, is another matter.

Most AOL services, including software and e-mail, will now be free to broadband users. This effectively eliminates the need for high-speed customers to pay $15 monthly subscription fees. The company will continue to provide low-speed dial-up service for $9.95 a month. But customers will be encouraged to switch to broadband connections, company executives say.

The company intends to cut about $1 billion in subscriber-related costs and refocus energy and dollars on expanding site traffic. It hopes to cash in on the vibrant Internet advertising market, which is expected to grow more than 30%, to above $16 billion this year, according to New York researcher eMarketer.

WALL STREET CHEERS. Many analysts see the new advertiser model as both a positive and necessary step to keeping AOL relevant in the post-dial-up world. The company lost more than a million subscribers in the U.S. and Europe in the past quarter. AOL's subscription revenues declined about 11% over the past year. Meanwhile, AOL's advertising revenue jumped 40%, to $449 million, in the last quarter alone.

"I think it clearly sounds like it is the right plan because otherwise they would keep losing subscribers left and right. And the business has changed from a subscriber model to an advertiser model," says Alan Gould, an analyst at Natexis Bleichroeder. "One of the telling statistics today was their ad revenues," adds James Goss, an analyst at Chicago-based Barrington Research, who has a positive rating on the stock. Investors also responded optimistically to the news. Time Warner's stock rose 2.58% Aug. 2 after it announced AOL's restructuring and a 15% overall revenue growth.

During a call with analysts, Time Warner President Jeff Bewkes argued that the plan would both stop users from leaving AOL and attract new eyes along with new advertising dollars. "Our members don't want to leave, and they tell us the No. 1 reason why they leave AOL when they switch to broadband is price. So we are going to stop giving our members to our competitors," Bewkes said. "This plan will remove the biggest barrier for our members staying with AOL as they move to broadband…There is [now] no reason for anyone to leave AOL."

IS IT ENOUGH? Removing the reason to leave, however, is not the same as giving people a reason to stay and play. During the call, company executives maintained that many of the 6.2 million broadband subscribers would continue to spend the kind of time on AOL's pages that they spent when they were paying for the service. They also expressed confidence that they could entice the millions of subscribers who left AOL within the past two years, and now have new e-mail accounts, to "come home" to their old AOL e-mail.

In fact, Bewkes argued that despite AOL's pocketing of $150 million to $200 million in restructuring costs, the company would be able to return similar profits without subscribers, thanks to lower operating costs and ad dollars. Time Warner is even projecting consolidated revenue growth in 2009. "Essentially what we are saying is that even taking into account restructuring charges, we don't see any material step down in AOL's earnings for the year," Bewkes said during the call. "We think that if there is a bias it will be a slight bias towards the upside."

That outlook is a bit rosy for some analysts, considering the company was still pulling at least 75% of its revenue from subscriptions (see BusinessWeek.com, 7/31/06, "Will Less Be More for AOL?"). It stands to lose more than $1 billion from exodus of its high-speed subscribers to the free service, and it takes a lot of cuts and ad revenue to make that up.

"A BIT TOO OPTIMISTIC." "I think they are being a bit too optimistic in how many of the lost subscribers will still be spending the majority of the time on AOL," says David Hallerman, a senior analyst at eMarketer. "When you are a broadband subscriber and you are paying extra for AOL to get your money's worth, you are going to be spending more time there. Without that extra cost there will be a fair percentage of former subscribers that will be spending less time on AOL."

Adds Jennifer Simpson, an analyst with Boston-based Yankee Group, "AOL will have a great difficulty reaching out to the people within the past two years that have become inactive because those people have migrated to service providers such as Yahoo! (YHOO ) and Google (GOOG )."

Gould cautions that AOL also shouldn't expect to continue to see 40% ad growth. "I think overall Internet advertising has to slow down…no market continues to grow at 30%," he says.

REASONS TO BELIEVE. Still, the company has reason to feel confident. AOL has the fourth-largest Web audience, and it posted second-quarter advertising revenue of $295 million. That figure was higher than even Microsoft's MSN network (MSFT ). In recent months, AOL has gained market share against Yahoo, which reported $637 million in ad revenue in the past quarter. Google is still the leading Web advertising outlet, with $953 million in second-quarter ad revenue.

AOL also has content that is attractive to advertisers. It recently launched an attractive video site that includes content from the now-canceled WB network as well as discontinued classic shows. It also owns the popular Mapquest site, Moviefone, and name brand Netscape. "I think they will get additional users, and if their focus is on video and audio to some extent, they are playing to their strengths," says Goss. "And I think that there is a certain stickiness and comfort level with having something available that you are used to."