The Internet Is Mr. Case's Neighborhood Techies hate it, but in cyberspace America Online is the only brand that counts. Led by a former P&G marketer who's more TV Guide than Wired, AOL is transforming itself into a real--and profitable--business.
(FORTUNE Magazine) – To understand the power of America Online, talk to Larry Rosen, the founder of N2K, an online retailer that wants to become the dominant seller of music on the Internet. Last year, shortly before going public, Rosen agreed to pay $18 million--nearly twice his company's annual revenue--to make N2K the exclusive music retailer on AOL. He also sold a small stake in his company to AOL, at a favorable price. A sweet deal for the online service? Sure, but Rosen didn't have much negotiating power. "When you see that 40% of all online traffic is coming through AOL," Rosen says, "you've got to be there."
Chris Holden learned that lesson the hard way. Holden is the CEO of Kesmai, a subsidiary of News Corp. and a supplier of interactive multiplayer games to AOL until last summer, when it was displaced by an AOL-owned games company. Within weeks 92% fewer people were using Kesmai's games, and its business all but collapsed. The company is now suing AOL, alleging antitrust violations. Says Holden: "AOL is clearly abusing its monopolistic power to squeeze out anyone who competes with its own games company."
Only in cyberspace could an outfit thought to be in mortal peril just 15 months ago now stand accused of wielding a monopoly--by a company owned by Rupert Murdoch, no less. America Online's newfound power, its sky-high stock price, and, yes, its profits represent a remarkable, unlikely triumph. Headquartered on a suburban strip in Dulles, Va., far from the techies of Silicon Valley and the media moguls of Manhattan, AOL has been underestimated for years by competitors, investors, and pundits alike. They were all dead wrong. AOL has crushed its rivals, buying CompuServe, beating down Prodigy, fending off challenges from AT&T and Microsoft, and deftly embracing the World Wide Web. Today AOL is the only brand that counts in cyberspace, an online Hertz with no Avis in sight. While most Internet companies are small-time startups awash in red ink, AOL has become the first new-media company on a grand scale, more comparable to Newsweek or a cable company like TCI than to Netscape. In the fiscal year that ended last June, AOL collected revenues of $1.4 billion; this year they should reach $2.5 billion. Analysts project profits of $110 million. With CompuServe, AOL captures about 60% of home use of the Internet, overwhelming the hundreds of big and small companies competing to take people online. All are now playing catch-up to AOL, and they're falling further and further behind--a new Internet user signs up every two seconds, and the majority choose AOL.
Wall Street is swooning. In the past year investors have driven the stock up from the $30s to $115 per share--well over 100 times earnings. AOL now has a market capitalization of $13.8 billion, as much as Washington Post Co., New York Times, and Dow Jones combined. "AOL has reached mass media status," says analyst Paul Noglows of Hambrecht & Quist.
With more than 11 million paying subscribers, AOL reaches about as many homes as cable operators Time Warner or Tele-Communications Inc., and it's adding more than 10,000 users a day. AOL has more subscribers than Time, Newsweek, and U.S. News & World Report combined. On weeknights during prime time, the number of people logged on to AOL peaks at around 650,000, putting it in a league with cable networks MTV and CNN. Most important, users spend an average of 51 minutes a day plugged into AOL, up from 14 minutes in 1996. According to Nielsen, those minutes on AOL come at the expense of television: Users say they're watching less TV. And AOL subscribers aren't techies--they're regular, slightly upscale folk who happen to own computers, and 52% of them are women. This audience is AOL's most valuable asset, more valuable by far than its infrastructure or technology.
For a decade Steve Case, the thoughtful 39-year-old CEO of AOL, has focused on building that audience. He lost a billion dollars along the way. Now he's ready to milk his creation for every dollar he can. He's selling the eyeballs to advertisers, he's charging retailers steep fees to set up their online stores in his neighborhood, and for good measure he's asking his subscribers themselves to pay more for the privilege of hanging out with their 11 million compatriots. Nobody else in cyberspace has this kind of clout.
Case is a shy and unassuming CEO, a worrier warrior who would never claim superpower status for AOL. "It's only the second inning," he likes to say. "And this is a world that can change overnight." He frets, rightly, that telcos, cable companies, and Microsoft would like to put him out of business. When he met Sky Dayton, the founder of an upstart Internet service provider called EarthLink, Case told the 26-year-old, "I'm not going to let you sneak up on me like we snuck up on CompuServe and Prodigy."
Case knows that on the Internet, size guarantees nothing. He didn't simply overtake CompuServe and Prodigy (the creation of the best brains at CBS, IBM, and Sears); he outsmarted just about every media and communications giant pursuing the holy grail of interactivity. John Malone's TCI was going to merge with Ray Smith's Bell Atlantic to build the information superhighway. Time Warner's Gerald Levin sank millions into set-top boxes in Orlando. Michael Ovitz brokered a deal between Howard Stringer and the telcos to do two-way television, MCI and News Corp. joined forces, and AT&T sold Net access to long-distance customers for $4.95 a month. And then there was Bill Gates--creating the online service MSN, launching MSNBC with NBC, investing in cable operator Comcast, buying WebTV, even hiring pundit Michael Kinsley to take a stab at the content biz. Whew. What were the odds that from that crowd Steve Case would emerge as the winner?
Case always thought the odds were pretty good. Even in the late 1980s, when AOL could barely pay its bills, Case's faith never wavered. "In a little company everybody's got to believe," says Marc Seriff, an MIT-educated programmer who was AOL's first head of technology. "But there needs to be somebody who believes no matter what. That was Steve. Steve believed from the first day that this was going to be a big deal."
Case's own road to the future began inauspiciously. Long before anyone was talking about E-mail, chat rooms, or the information highway, Case plugged a telephone cord into the modem of his Kaypro computer and tried to go online. It wasn't easy--he spent thousands of dollars on the computer and modem and software, and weeks getting them to work before he finally logged on to a now-defunct online service called the Source, all to read some tiny white letters that scrolled across a green screen at a maddeningly slow pace.
Others would have quit. Case was entranced. "Despite how hard it was to set up and use, and despite how expensive it was, something magical was happening," he said. Never mind that the home computer then--this was 1982--had barely emerged from Steve Jobs' garage. Case recalls thinking, "The ability to sit at your desk and access information and connect with people all over the world--how could that not, over time, be a huge business?"
That story is part of AOL lore by now, but it is worth retelling, because out of that experience came Steve Case's one Very Big Idea. Behind AOL's phenomenal success is Case's bedrock belief that the service must be easy to try and easy to use. Even now it's too complicated, he says. "the proof is that we have 5,500 people on the phones talking to users, explaining to them why something we think is simple is, in fact, something they think is too hard."
This may seem obvious in hindsight, but sophisticated computer users for years derided AOL as the "Internet on training wheels." Case knew that the "digerati"--people who see herky-jerky video streaming over the Internet at two frames per second and say, "Cool"--are outnumbered by the rest of us, who say, "Why would I watch this when I can watch TV?"
Case designed AOL for the rest of us. (I've been a member since 1994. My mother, wife, and 13-year-old daughter--whose own take appears later in this article--are regular users too.) And it works, just well enough. AOL is the simplest E-mail you can find. It's news from ABC, the New York Times, and cybergossip Matt Drudge, as well as sports, weather, and personal
finance. It's a convenient way to order books or flowers. Pet lovers, motorcyclists, recovering alcoholics, and Civil War buffs--they all have their own hangouts inside AOL. So do the men and women with screen names like "Lonesum2nt" and "Pleezme" who flock to chat rooms--15,000 of them on any given night--called The Flirt's Nook, The Hot Tub, and Married and Cheating. Some retreat to private spaces to have cybersex, and more than a few have turned their virtual affairs into real ones. None of this is about cutting-edge technology--it's about finding easy ways to do online the things we do off-line, like communicate, get information, shop, socialize, and fall in love.
When you meet Case, you understand why he gets it. He's so, well, ordinary. Nothing about him says media mogul--he wears polo shirts and khakis, lunches on turkey sandwiches and Sun Chips, and has the boyish good looks of an aging fraternity brother. He's brainy, but not in the "out of the box" way prized by famous techies who launch their careers with nifty pieces of software or a breakthrough technology. No, Case is basically a huckster. He started out marketing hair conditioner for Procter & Gamble and then tested exotic new combinations for Pizza Hut, only to find that people preferred plain tomato and cheese. Maybe that explains why AOL is the hold-the-toppings online service.
Soon after AOL went public in 1992, Case and Jan Brandt, AOL's marketing czar, devised a harder sell than any ever tried by an online service--sending out software disks by direct mail to millions of computer owners, offering them free trials of AOL. The tactic had worked for Brandt in her previous job, where she'd recruited new members to the My Weekly Reader book club by sending them a free book rather than a pitch letter. Before long there was nowhere to hide from AOL. "My job," says Brandt, "was to give new meaning to the word ubiquity." Pop singer Sarah McLachlan's best-selling CD, a box of Rice Chex, and an issue of Reform Judaism magazine delivered AOL software to unsuspecting music lovers, cereal eaters, and worshipers. Disks turned up with videos at Blockbuster, with meals served on United Airlines, even with deliveries of Omaha Steaks. (First someone had to make sure that freezing the disks wouldn't damage them.) Today Brandt's wall features a couple of framed disks, captioned WE COME IN PEACE and RESISTANCE IS FUTILE.
Membership soared, from 155,000 at the time of the IPO to 4.6 million at the start of 1996. But AOL could not handle the hypergrowth, in more ways than one. For starters critics charged that AOL was wildly overspending. "Do the first ten years of AOL represent the creation of an audience or the marketing equivalent of a Ponzi scheme?" asks a TV executive who deals with the company. The only way AOL could record the occasional profitable quarter was by treating its enormous marketing costs as capital expenses, amortizing them first for one year, then for two. The company was within its rights, but the aggressive accounting looked like little more than a sleazy way to buttress the bottom line. Stung by the critics, AOL abandoned the practice and took a whopping $385 million write-off in October 1996. That wiped out every nickel of its so-called profits.
Case, who had never run a big company, was also losing control of his organization. AOL had grown helter-skelter, from a few hundred employees to many thousands. (Today there are 9,500.) "This place was entrepreneurial to the point of confusion," says Myer Berlow, a veteran advertising executive hired in 1995. "Everyone got to do what they wanted." To his credit, Case knew he needed help. But William Razzouk, a former Federal Express executive he brought in to run day-to-day operations, flamed out after just four months on the job.
Worst of all, AOL was failing its customers. In December 1996, AOL replaced its $2.95-per-hour usage charges with flat-rate pricing, at $19.95 a month. The results were predictable--customers spent more time online; systems overloaded; users felt justifiably betrayed, as did advertisers and content providers who counted on AOL; and regulators forced the company to offer refunds.
Yet Case, ever the true believer, saw a silver lining in the crisis. "What was happening, for really the first time, was that we impacted people's daily lives in a significant way," he recalls. "Suddenly, almost overnight, we became part of everyday life. That's why there was this national outrage and tremendous passion and frustration, because people needed us, and many of them loved us, and we had disappointed them. It was a coming of age for the medium." Amazingly enough, people kept signing on--in droves. AOL's competitors still can't quite believe it. "How many businesses do you know where you can treat your customers like shit and still grow your market share?" gripes the CEO of a popular Internet content company.
Still, Wall Street had this funny idea--that the time had come for AOL to make a profit. "We are just asking," wrote Morgan Stanley analyst Mary Meeker as she downgraded the stock, "that a company with a $1.6 billion revenue run rate, eight million customers, and a great (in spite of itself) brand name demonstrate that it can make a little money." Case needed someone who could finally translate all these customers into a real business.
He hit the jackpot with his next choice--Bob Pittman. Pittman was a marketing whiz kid, a boy wonder who quit college to work in radio, rising to become a twentysomething star programmer at NBC. He then co-founded MTV and helped create the brilliant "I want my MTV" advertising campaign that forced reluctant cable operators to carry the channel.
But after leaving MTV in 1986, Pittman drifted. He produced a cheesy talk show, ran Time Warner's Six Flags theme parks, and then became CEO of Century 21, where he built an online service for real estate agents and made AOL's first million-dollar ad buy. All that was fine, but Pittman missed the spotlight--friends like Tom Brokaw and David Geffen couldn't care less about franchising real estate.
So Pittman was thrilled when Case asked him to become president of AOL. The son of a Mississippi preacher, Pittman had found a new mission. "This is the next monster business in America," he declared. Now all he had to do was prove himself right.
In its essence the problem facing AOL was simple. Providing Internet access, by itself, is a lousy business. Price competition is intense, and as more people spend more time online--good news, you'd think--costs soar. Last year, for example, AOL added roughly 2.9 million members, so it had to invest $700 million in its access network and in customer service.
Pittman, 44, has attacked costs. "I'm a maniac on spending," he boasts. Just recently he laid off 500 people from CompuServe and another 200 from AOL Studios, a money-losing content unit, as both were brought under his control. (That was a setback for Ted Leonsis, AOL's brash production chief, who loved to talk about competing with Seinfeld. But Leonsis, like everyone else who has tried, found that creating compelling new media content isn't easy.) Pittman has also used AOL's scale to drive hard deals with backbone providers like WorldCom, gradually pushing AOL's cost of connect time down from 95 cents an hour to less than 50 cents an hour. Most important, as the AOL brand built strength, he was able to spend less on marketing. In the past 24 months AOL's cost of acquiring a new subscriber has dropped from $375 to $90.
But as Case and Pittman knew, cost cutting alone would never make AOL a consistently profitable business. The key was to leverage AOL's massive subscriber base for all it was worth. Pittman would have to squeeze big dollars out of retailers, advertisers, publishers, programmers, and anyone else looking to reach the millions of eyeballs on AOL. The question was: How much could he get?
The answer came from a man named Dan Borislow.
Before they met early last year in New York City, Pittman had never heard of Borislow or his fledgling long-distance company called Tel-Save. But Borislow, 36, a tough-talking entrepreneur, got Pittman's attention in a hurry. "I have a $50 million check in my pocket," he said.
Like Case, Borislow had one big idea. His competitors were planning to simplify customers' lives by bundling local, long-distance, cellular, and Internet access on one bill. "Why not no bill?" wondered Borislow. If Tel-Save could sign up new customers online, bill them online, and charge their credit cards, he could cut costs dramatically. "It costs me a dollar to send out a bill, another 35 cents to cash a check," he says. Marketing online would save money too. "When all is said and done, we're saving as much as 50% of the cost of doing business," he said. With AOL's help, he believed, he could underprice everybody.
Borislow was a Prodigy user, but he took his idea to AOL because it was bigger--and because it was in trouble. "This company was having the worst time it would ever have in its life," he said. "It was a perfect opportunity for us." AOL had discussed alliances with AT&T and Sprint, but Borislow was ready to roll. "He reminds me of Ted Turner," Pittman said. "He's a guy who has a vision and is absolutely certain that his vision is correct." And he was willing to pay cash.
Ultimately Borislow paid $100 million for exclusive access to AOL and its subscribers for three years. AOL also got warrants in Tel-Save and a share in the future profits from the long-distance business. Says David Colburn, AOL's chief negotiator: "The deal said that this is a real medium that can generate major dollars--that online is a very special marketplace and that AOL can make money. And it said it at a time when we were under tremendous fire."
Suddenly Pittman and Case had a business.
A flurry of deals followed. CUC International paid $50 million for AOL to carry its online discount-shopping service. Preview Travel paid $32 million to become the service's online travel agent; 1-800-Flowers bought the flower concession for $25 million; and N2K paid $18 million to become the sole music retailer. Colburn, a tough-minded lawyer, also brought in fax services, greeting cards, and classified ads--in most cases, pitting bidders against one another. Sometimes he made deals with both sides. After Amazon.com paid $19 million to become the bookseller on AOL's Website, aol.com, Barnes & Noble agreed to a $40 million deal to be the exclusive book retailer inside AOL.
It's too early to tell if these multiyear deals will be as good for its partners as they've been for AOL. The preliminary signs are positive. N2K beat analysts' estimates with fourth-quarter revenues of $4.8 million, the bulk of which came through AOL. When the Titanic soundtrack was promoted on AOL's welcome screen, N2K sold 750 CDs in 20 minutes. Since its December launch, Tel-Save has signed up more than 300,000 customers for long-distance service priced at a rock-bottom 9 cents a minute. In January, AT&T announced a 9-cent plan for its Internet customers. "This might be the first time ever that somebody one-fiftieth their size has prompted AT&T to put out a competitive offer," boasts Borislow. Last Christmas J. Crew offered a 20% discount to AOL members and sold more clothes online than in all but its New York City retail store.
"Now," says Pittman, when asked about the commerce business, "the only question is, How big, how fast?" In February, Intuit agreed to pay $30 million to sell financial services. Ahead are deals with sellers of insurance, office supplies, groceries, and most intriguingly, digital imaging. Once families put pictures in their AOL Photo Album to share with relatives and friends, switching to another online provider will seem like a real pain. Insiders say AOL is close to an agreement with Kodak.
Commerce deals may be clicking, but advertising, long thought of as the way for Net businesses to reap profits, has proven less lucrative. When Pittman does win a big account, AOL gets a payoff that can last years. Brokerage firms like DLJdirect and E*Trade pay nearly $500,000 a year for space on AOL's bustling Personal Finance channel. When a new customer opens an account as a result of an ad, AOL gets a slice of all future commissions. "If you're DLJ or E*Trade," says Berlow, who runs AOL's 130-person ad sales department, "you're going to pay me on every single trade, forever."
More often advertisers are taking a wait-and-see approach. With hundreds of Internet content sites selling almost unlimited ad space, rates are falling across the Web. The AOL audience, while substantial, is splintered across thousands of chat rooms and Websites. Not surprisingly, most leading companies prefer to sell their cars and sneakers on TV and in print. Those sponsors like Ford, Toyota, Coca-Cola, and Warner Bros. that do go online say they'd rather invest in their own Websites than spend money on AOL. "They're only sticking their toes in the water," laments Berlow. Says Pittman: "These companies study everything to death. They move incrementally." For months now Pittman and Berlow have been trying to sign up Procter & Gamble and PepsiCo. P&G has reportedly come around; an announcement could be made any day now. PepsiCo, by contrast, has resisted Pittman's best efforts to negotiate a stadium-type deal that would anoint Pepsi as the "official soft drink of AOL"--for whatever that's worth.
Pepsi won't pay, but Pittman has found others who will: Microsoft, CBS, and other online programmers who are desperate for an audience. He's not really selling them ads. He's selling them promotion of their content sites, like Slate and CBS Sportsline. In so doing, Pittman has begun to reverse the "traditional" way of doing online content deals--when AOL started up, it shared revenues with publishers, who gave the new service an imprimatur of respectability and invaluable promotion in the real world. Some major media outlets, like ABC News and MTV, still get royalties in exchange for valuable TV exposure. Time Warner, FORTUNE's parent company, gets paid for programming from Warner Bros. Online and Teen People, as well as other content.
More frequently, though, it's Pittman who's cashing the checks. The former cable guy has taken a page from the playbook of TCI and John Malone, who, whenever they can, extract payment and even equity from programmers who need carriage. Like Malone, Pittman plays hardball. He booted the Dow Jones Business Center off AOL because Dow wouldn't pay up. Seeking to build its brand, Bloomberg L.P. stepped in, paying AOL an undisclosed amount for the right to deliver similar data. Nor does Pittman play favorites. iVillage--a company partly owned by AOL--produces Websites for women. But even iVillage pays AOL for carriage--about $3 million a year. And just to keep iVillage on its toes, AOL has created Electra, its own wholly owned Website for women.
"It's all about leverage," says Barry Schuler, AOL's equivalent of a television network programming executive. "Any media company is leveraging their relationship with their audience. Period. End of discussion. You build the audience, you figure out how to extract value.... We have a very big ability to control the flow of our audience."
Which means that if you don't play by AOL's rules, you're out of luck. Just ask Kesmai. The News Corp.-owned company creates online games that can be played by hundreds of people simultaneously. Last year AOL acquired a competing company, now called WorldPlay, and gave it the anchor position on its games channel. Others, including Kesmai, were shoved into the background--destroying their businesses and illegally limiting consumer choice, Kesmai charges. A trial date for its lawsuit will be set this month. AOL denies any wrongdoing and points out that other displaced games companies relocated, with their customers, to the Web.
Call this the dark side of leverage--the newly disciplined AOL will try to hit its quarterly profit targets even if that means trampling on some so-called partners. Many feel exploited. "Pittman wants to build one brand, and that's AOL," says a disgruntled content provider. "It's like the networks deciding they aren't going to build Seinfeld or Melrose Place, but only their own brand." If that's Pittman's strategy, it's working. Surverys show that AOL's name recognition dwarfs that of Yahoo, Netscape, or even the Microsoft Network.
The real proof is in the numbers. For the first time in its history, AOL looks like a company that can generate profits for years to come--"a New Age blue chip," in the words of Morgan Stanley's Mary Meeker, a bull once again. For the past two quarters, AOL has reported profits, with no visible accounting gimmicks. Advertising and commerce revenues totaled $85 million during the December quarter, up 93% from a year ago. Since most commerce deals are spread out over time, AOL has $320 million in guaranteed payments that it has not yet booked as revenues. If Internet commerce and advertising grow as projected, there's nowhere to go but up for AOL.
Now the company is applying leverage to its own subscribers. Starting in April, the price for unlimited access to AOL goes up $2 a month, meaning most users will pay $21.95. The increase was a clear signal that at the new AOL, profits matter more than growth. Besides, as analyst Robert Seidman, publisher of Seidman's Online Insider, predicts: "People won't leave in droves. Inertia is a very powerful thing." Switching online services means finding a new provider, loading new software, and creating a new E-mail address.
So what could stop AOL? One danger is that Case and Pittman try so hard to please Wall Street that they create legions of dissatisfied customers. AOL users already endure annoying pop-up advertisements and screens cluttered with banners. Service remains spotty, occasional system outages and E-mail glitches seem unavoidable, and members who call AOL's 800 number for guidance are steered to online help desks rather than given instant handholding on the phone. No one will ever accuse AOL of being the Nordstrom's of the Net.
Wal-Mart will do just fine. Barring a technological breakthrough as unforeseeable as was the rise of the Internet, the only thing that could really wreak havoc on Mister Case's neighborhood is a strong competitive challenge. So far, prospective rivals like IBM, CBS, Sears, AT&T, and Microsoft have fallen short. None has Case's singular focus. "If Bill Gates and Steve Ballmer and all those guys didn't do anything but online media, they probably would have done a great job," says veteran AOL programmer Leonsis. The biggest players haven't given up--the lure of the Internet's potential is too great. Sprint recently acquired a 30% stake in Earthlink, the well-regarded Internet access provider that promptly launched a "Get out of AOL free" promotion. MCI and Yahoo have joined forces to offer $14.95-a-month access to MCI long-distance customers. Time Warner and @Home have talked about merging their cable-modem operations, which offer lightning-fast access to the Internet. "The telcos and cable companies are really coming after AOL's customers," said Kate Delhagen, an analyst at Forrester Research in Cambridge, Mass., who predicts that AOL will soon start losing market share.
With Pittman running the day-to-day operations, Case gets up each morning thinking of ways to counter these threats. "There are a bunch of people who believe it's their manifest destiny to put AOL out of business, and it's my job to make sure that doesn't happen," he says calmly. The newest version of AOL's software is said to be so easy to use that the company could save up to $40 million a year in customer-service costs. AOL 4.0, as it's called, offers a host of new features, including radio channels that can play in the background (with commercials, of course) while users read E-mail or chat. AOL is also making it easier for users to check their E-mail from work, through the heavily trafficked aol.com Website.
By year's end Case and Pittman plan to introduce AOL Direct, a personalized digital newspaper that users can opt to have automatically downloaded into their PC's. They will invite the 950,000 members who have created their own home pages to move into Hometown AOL, where home pages will be grouped by common interests or regions. They are also considering an "AOL TV" product to compete with WebTV.
They have one more hedge against the future, a luxury the company has never enjoyed before: $750 million in cash. That could be used to make new acquisitions or to secure AOL a place on any up-and-coming delivery platform. Inside AOL, there's also talk about negotiating an all-encompassing peace pact with Microsoft, the rival Case & Co. fear most.
None of this means that AOL is impregnable or that its lofty stock price can be sustained. But the strength of AOL's brand does mean that knocking these guys off their perch will be harder than ever. As Pittman says, "I remind people all the time that Coca-Cola does not win the taste test. Microsoft is not the best operating system. Brands win." That's why the business of cyberspace has become AOL's game to win or lose.
REPORTER ASSOCIATES Liz Smith, Wilton Woods