CVC was not alone in this market. IBM and Sears had set up a service named Prodigy, and there was also CompuServe, owned by H&R Block Inc., the tax advice specialists, and a latent threat from the telecommunication companies, who were all considering the provision of such a service. By 1991 CVC had changed its named to Quantum Computer Services and had grown its customer base to just over 100,000. The online service it provided was known as America Online (AOL). Quantum had reached yet another potential decision point. In this case, the decision was either to be sold or go to the stock market to raise new capital. The main potential purchaser was CompuServe, which made an offer of $50m, some $10m less than Kimsey was willing to accept. The shortfall in the offer, combined with Steve Case’s resistance to the sale, led to the decision to take the company public instead.
Quantum changed its name to AOL and in March 1992 an IPO took place. At that time its number of subscribers had grown to 155,000. A total of $23m was raised, of which $11m went to those selling shares in the offer and $10m to the company, with the balance of $2m going in underwriting and commission charges. AOL as a public company had been born. Exciting as life had been up to to this point, it became much more so thereafter. In the early 1990s, neither the World Wide Web nor browsers had yet appeared; online services therefore carried only limited appeal. As the new Internet era dawned, levels of interest in online services increased accordingly. By 1992, Paul Allen, co-founder with Bill Gates at Microsoft, had built up a stake in AOL and was seeking to gain control. He was only thwarted by a last-minute ‘poison pill’ defence.
Gates also expressed an interest in the company to help add an improved online facility to the Windows service he was developing. Microsoft signified a willingness to pay at least $270m and possibly $400m for AOL, a substantial figure given AOL’s 250,000 subscribers and chequered financial history. The AOL board decided to maintain its independence, but only on a split decision. Given the difference in subscriber bases between AOL and its two main competitors, Prodigy and CompuServe, and the likelihood that it would also have to compete in due course with Microsoft, this was a brave decision. Whether or not it was a suicidal one was debatable at the time. From that point forward, AOL effectively opted for a ‘win or bust’ strategy entirely in keeping with the history of its original founder, Von Meister.
In 1993, a marketing strategy was developed which has been described as a carpet-bombing campaign. In essence it was a straightforward mailshot – but on a scale that had never been seen before, in which a staggering 250 million discs were sent out to customers, giving them a period of free access to the service. The campaign was an unqualified success, bringing in massive numbers of new subscribers and moving AOL to centre stage. Of the available online services, AOL was the most customer-focused. The surge in users created huge technical problems, but AOL worked hard to remove potential hurdles. The next stage was the arrival of Microsoft’s online service and the emergence of both the World Wide Web and the browser. The challenge from Microsoft was simple. If its online service could be bundled with Windows, and other services excluded, in all likelihood it would eventually dominate the market, pushing AOL to one side. The threat it faced from browsers and the Internet was not just that new service providers would appear, but also that the market would be segmented and a brutal price war break out.
10.11 – The second warzone: subscribers to AOL, CompuServe, Prodigy
Source: Telecommunications Reports International.
Browser wars
To address these threats, Steve Case sought first to alert the Department of Justice to the consequences of bundling, and then to build up AOL’s defences by funding content providers such as The Motley Fool and iGolf. AOL had tried to obtain a stake in Netscape during its VC funding round, but found itself shut out due to potential conflict of interest. Instead AOL purchased the BookLink browser and NaviSoft, a Web publishing and development tool producer. The strategy was relatively straightforward: whether you build it or buy it, do it now. This strategy was made possible by the strong performance of AOL’s share price, which provided it with a currency with which to make acquisitions. At the same time AOL started to build out its own network so as to reduce its dependence upon third parties that might potentially one day hold it to ransom. In addition, AOL sought to internationalise its service by signing an agreement with the German publishing company Bertelsmann. In such a frenetic atmosphere, it was inevitable that some deals would prove mistakes, but the danger of not doing deals was to risk suffering the fate of the more conservative CompuServe. The latter’s strategy consigned it to a future of pedestrian growth and life as a niche player in the industry.
The refusal of Netscape to accept AOL as an investor might well have proved a blessing in disguise. Although Netscape’s browser was the clear market leader, and would undoubtedly have benefited AOL, losing it did not hurt its growth dramatically. AOL was in a battle with Microsoft and its competing offering MSN, but the online service battle was of less significance to Microsoft than the browser war. The browser war threatened the core of Microsoft’s profitability, which was its Windows operating system. If Netscape’s browser could become the industry standard and the Internet was truly the future, then by implication Windows stood to lose its dominant position. Certainly this was the future that Netscape was trumpeting. Bill Gates viewed this as the most serious threat to his company.
AOL was therefore in a position reminiscent of Rockefeller during the railroad wars. Indeed, the agreement AOL subsequently signed with Microsoft had a provision for payments to convert Netscape Navigator users to Windows Explorer. The two browser war protagonists both required an alliance with AOL to cement their positions. The difference was that Netscape believed AOL had no alternative, while Microsoft believed a deal was vital. In 1996, Case completed a series of deals which put AOL in a position from which it could become the dominant Internet force. First, in March, a deal was announced with Apple which put AOL on all Apple Macintoshes and also passed Apple’s eWorld online service to AOL. Shortly thereafter an alliance with Netscape was revealed whereby AOL would license Netscape Navigator and receive space on the Netscape Web. AOL also completed a deal with AT&T in early March, but the denouement was to come with an entirely unexpected arrangement. Unlike Netscape, Microsoft had been assiduously courting AOL. Microsoft’s browser was free, while Netscape’s was not. And, unlike Netscape, Microsoft could bestow the ultimate prize for any ISP, which was an information folder packaged with Windows 95 software. Since AOL’s Netscape deal had no exclusivity clause, Case was free to sign the second deal with Microsoft – a deal the effect of which was to ensure the eclipse of Netscape as the dominant browser company.
From this point on, the future for AOL, while not assured, was to follow a more conventional route. This path involved a greater focus on the company’s financial position and the changing competitive landscape. So far as the financial position was concerned, it was ironic that AOL, for all its new economy credentials, had been using the kind of accounting policies favoured by ‘old economy’ companies and fast-growing conglomerates, namely early recognition of revenues and deferred recognition of expenses. AOL sought to amortise the cost of the customers it acquired over an extended period. This had the benefit of boosting revenues during periods of rapid growth, but undermined them when growth began to slow. In regard to the competitive landscape, after some years of expanding rapidly through market growth against relatively moribund competitors, AOL was now faced with a rapid influx of new entrants. These entrants found financing increasingly easy as the stock market reacted to Internet companies with increasing favour. They typically priced their service packages at an aggressively low price in order to obtain rapid subscriber growth. A final problem for AOL was that a substantial proportion of AOL’s revenues still derived indirectly from the pornography industry, which had quickly realised the power of the new distribution medium and in particular the use that could be made of AOL’s private and unpoliced chat roo
ms.
So despite its success in establishing a dominant market position, AOL was not without its challenges. Putting these factors together produced a company whose historic revenues had to be restated, whose future revenues were under threat and whose moral standards were in question. The problem facing AOL could be summarised as to somehow increase revenues, cut prices, reduce the customer churn rate and maintain growth, while at the same time distancing itself from the increasing reaction to revelations about the role of the Internet in paedophilia and pornography. The year 1996 therefore proved a difficult one, with little prospect of immediate improvement.
A new business model
Clearly revenues could not come from customer subscriptions since the move to flat-rate payments and unlimited usage had already begun. Revenues needed to be garnered from other sources, which primarily meant advertising. In the early years AOL had eschewed advertising. Indeed one of its pitches had involved pointing out the absence of advertising on its service. The business model soon changed, however, and advertising revenue became key. Since the medium was a new one, revenues did not immediately flood in. However, AOL proved to have established a sufficient brand presence and subscriber base in its own right that it was not long before retailers such as Amazon and Barnes & Noble had signed up.
10.12 – Selling sex helps AOL
Source: Rolling Stone, October 1996.
Moreover, content providers also found the rules had changed under the new regime. Although AOL managed to make the transition, it was not a smooth one. The move to flat-rate payments and unlimited access caused an overload on AOL’s systems of such proportions that the backlash against the quality of the service threatened the existence of the company. AOL was forced into a policy of reimbursement and compensation to head off legal moves and had to suffer the indignity of seeing its competitors produce advertising that pointed out AOL’s lack of service. Nevertheless the systems were eventually upgraded and with the new revenue model AOL resumed its inroads into the market share of its major competitors, to the point where, in a complex deal involving WorldCom and Bertelsmann, AOL obtained control of CompuServe. Thus, by October 1997, AOL had completed a remarkable transformation from pariah to victor. The continued evolution of AOL was not yet complete. Even as the ink was drying on the CompuServe deal a new plan was being made, this time for the acquisition of the now declining Netscape. Just over a year later a strategic alliance was announced with Sun Microsystems which involved the absorption into AOL of Netscape.
10.13 – AOL: from zero to hero
Source: Montage – sources in art itself.
Perhaps more than any other company, AOL can be said to have pioneered the growth in the Internet. At no time did it benefit from patent protection or licence agreements. It had to rely on its ability to react to circumstances and to take risks where this was needed. As such, it was forced to fight its way out of tough spots on many occasions. Fortunately the stock market environment in which it operated was a massive assistance. Although the market did react to negative developments, the valuation it was prepared to bestow at other times gave AOL enormous freedom to manoeuvre, culminating in its infamous merger with Time Warner in October 2000. When it was announced, this was the first major takeover of an ‘old’ economy company by one from the ‘new’ economy – put another way, of one with profits by one without. AOL used the strength of its share price and hence its market capitalisation to capture assets that would have otherwise been well out if its reach.
The story did not end there. In abstract, the logic of the AOL-Time Warner deal was impeccable. Putting together distribution and content has a long business pedigree and continues to be a key theme in markets. In practice the transaction proved to be a disaster, at least for Time Warner’s shareholders. When, in 2009, the rump of AOL was finally demerged from Time Warner, the latter’s chairman and CEO described the merger as “the biggest mistake in corporate history”. Aside from inflated revenue and shareholder lawsuits, the main challenge for the newly combined entity was that AOL was swiftly becoming out of date. The recession that followed the bursting of the stock market bubble in 2000 hit advertising revenues hard, while the move towards increasingly free distribution of print media began the demise of subscription models for Internet access, and the growth in broadband services created a new environment to which the company had few answers. AOL was left looking like a dinosaur as the telecoms companies provided free access, search companies grabbed advertising, and email was given away for free. In 2002 the company was forced to write down the goodwill associated with the merger by $99bn. After the demerger, AOL’s second incarnation as an independent company lasted just six years, with the one-time market leader acquired by the telecoms company Verizon for $4.4bn in 2015, a mere fraction of the value placed on it when the Time Warner merger was first announced.
AOL
AOL’s chequered financial history is readily apparent. In the early days, analysing the accounts required constant to-ing and fro-ing between different years in an effort to separate the operating results from other items such as acquisitions/disposals, financing and changes to accounting treatment. In many ways analysing AOL was the same as trying to analyse the acquisitive conglomerates of the 1970s and 1980s. The business never appeared to be in a ‘steady state’, making it difficult to estimate future operating margins and rates of subscriber growth. Some analysts argued that the changing nature of the business made this analysis fruitless, but such an argument was spurious. For any investor buying something, the more information that can be gained about the ‘substance’ of the something that is being bought the better. Sadly, for Time Warner, this did not appear to be a principle that was followed.
The background to the AOL merger was a gross revenue growth rate in excess of 50% but a cost of sales that had grown at least as fast as revenues. The main danger, though, was not the initial margin but the changing nature of the pricing model. The service had migrated from a charge-for-use environment to a flat-rate payment model for unlimited access. In other words, service providers were locked into a commodity offering with fixed revenues and variable cost. AOL attempted to address this by positioning itself as a content provider, but found itself caught between the scissor blades of competing access and content providers.
10.14 (a) – AOL before the Time Warner deal
Source: Thomson Reuters Datastream. AOL annual reports.
From a financial perspective, AOL was one of the few Internet companies that succeeded in bartering its ‘bubble’ valuation into a significant stake in another company that enjoyed the old-fashioned characteristics of revenues and assets. At the time of the merger, Time Warner had revenues of $32bn, four and a half times those of AOL and much higher operating margins. The deal was justified on the back of AOL’s faster growth prospects, but, as history records, those prospects turned out to be illusory. It is fair to observe that it was not just AOL’s share price that was inflated by the TMT bubble. Time Warner also benefited from a TMT-style rating. There were excess valuations on both sides of the deal. AOL succeeded in getting access to Time Warner’s content and branding, but more importantly, in a financial sense, it gained cash flow and profits. The deal was very much in keeping with the vision AOL had consistently espoused and confirmed its reputation for astute and opportunistic management. It was left to the stock market to face the cold reality of lower future earnings. The difference between AOL and some of its contemporaries is that it took the myth and traded it for the best available reality. It behaved logically in using its inflated share price to buy assets and hence reduce the downside risk to its market rating.
10.14 (b) – AOL after the deal
Source: Thomson Reuters Datastream. AOL annual reports.
The actual outcome proved worse than expected; not only did sustained profitability prove illusory, but the stability of the underlying core business was also slowly undermined by competitive pressures and a series of management missteps. In 2009 Time Warne
r completed the spinning off of AOL, returning it to the stock market as a separate listed company. After eight years of pedestrian performance during this phase, illustrated in figure 10.14, it was eventually purchased by the telecoms company Verizon for $4.4bn. That purchase price was 98% lower than the peak TMT bubble market capitalisation AOL had commanded at its peak.
The Yahoo story
The emergence of the World Wide Web brought with it a decentralised growth in information provision, in which links no longer followed hierarchical lines and instead sought to mirror more intuitive human thought processes. At least this was the original conception. The benefit of such a system was its ability to easily move through and between related documents. It avoided the constant need to reference back through hierarchical systems to find linked documents. The downside was that, in the absence of a hierarchy, finding specific pieces of information became a Herculean task. Hypertext could not simply replace the age-old library systems of cataloguing information. What it could do was provide a new and extremely powerful tool in accessing information once the correct starting point had been found. The World Wide Web provided the opportunity for masses of information to be accessed, but still lacked tools to find a way through the increasing morass. This was not immediately obvious in the very early stages, as available information was relatively eclectic, reflecting the predilections of the first users, who typically came from an academic or technical background. Equally, as there was no apparent commercial potential, few outside agencies had any interest in developing tools to assist information retrieval. As a consequence, the development of such tools emerged from individuals with a personal interest in the area. Two such individuals were engaged in postgraduate research work at Stanford University, but with a consuming interest in the Internet.
Engines That Move Markets (2nd Ed) Page 53