AOL's Formula: Does It Add Up? The online unit has a bold plan for getting more cash out of your wallet. Is it a vision, or just another mirage?
By Stephanie N. Mehta

(FORTUNE Magazine) – Does $159 a month sound like an outlandish amount to pay for your AOL service? Even as chastened executives of the year-old AOL Time Warner (parent of FORTUNE's publisher) are pledging to underpromise and overdeliver, operating chief Bob Pittman and the folks at the America Online unit he once headed are still throwing out brash goals and a big number. To wit: the plan to nab $159 of a home's monthly disposable income.

To be fair, Pittman isn't talking about raising the price of an AOL subscription to $159 a month. And he isn't saying that he'll get that $159 in 2002, or even in 2005. What he's saying is that in the long term, in a decade or so, his guesstimate is that a U.S. household will pay the AOL division up to $159 for a monthly cornucopia of interactive entertainment, information, and communications services. And hey, isn't such a convergence of services the premise--indeed, the very promise--of the AOL-Time Warner merger?

There's a reason Pittman might like you to focus on--and believe--that number. While the short term looks stable, it's nothing like AOL's glorious past. The online service had been growing for years, with revenues soaring 43% in fiscal 2000 and 53% the year before, and profit margins on the typical $23.90 monthly subscription remain high. But many analysts believe that the division's primary business--getting Americans online over relatively slow narrowband connections--is a maturing one. One indication of that: AOL membership grew just 24% in 2001 (to an admittedly impressive total of 33 million subscribers worldwide), down from 30% growth in 2000 and 36% in 1999. Ad revenues may--or may not--be helped by ballyhooed efforts at "synergy," selling ads across all the company's divisions, but in the short term the AOL unit will be hurt by the ad recession. And AOL's international operations, which the company has touted for years as a potential growth engine, remain hampered by regulatory challenges and continue to lose money.

But if Pittman someday manages to get his $159, AOL can get back to telling a thrilling tale of breathtaking growth. If the AOL division can transform itself from an old-school provider of online access into a one-stop shop for movies, music, interactive videogames, phone service, and more, AOL Time Warner may prove that the merger deserves all the hype it once enjoyed. Heck, it may even show the world what "convergence" really means.

Never mind that telecom and Internet companies have been chasing similar pipe dreams of bundling together services for a decade. Or that AOL's average revenue per subscriber, including ad revenue, is heading in the wrong direction, down 2% sequentially in the third quarter, according to Morgan Stanley estimates. Or that 2001 cash flow growth for the unit is widely expected to go up by a third of what it did in 2000. Or that AOL has far fewer customers paying it hefty monthly fees for broadband access than do the big cable and phone operators. In the face of those troubling facts, Pittman invokes the standard AOL defense when confronted with the possibility that it just might fail: It hasn't so far. "Look, three or four years ago in the press everyone was saying AOL was going to die because @Home was going to kill us," says Pittman, pointedly referring to the cable industry's Internet service provider, which will close its doors in February. "Turns out we were right, and they were wrong."

The man responsible for implementing Pittman's ambitious plan is Barry Schuler, CEO of the America Online unit. Like Pittman, Schuler came to the merged company from the AOL side, and like Pittman he possesses the seemingly unassailable view that past is prologue for scrappy AOL. For example, he flatly rejects the notion that no company has ever significantly increased its share of the family wallet. "We've done it," Schuler insists. "Five or six years ago AOL was getting about $15 out of a household. Now we have tons more households, and we're getting $25, plus our members spent $33 billion in online shopping last year." And he's right, even though much of the per-household increase comes from raising subscription prices, and even though almost all of that $33 billion goes to the stores on AOL's service, not to AOL itself.

Now, to zero in on that $159 a month, Schuler must transform AOL from a company that excels at selling a single proposition--reliable, easy-to-use online service--into a company that will hawk many, many different offerings. And unlike five or six years ago, when Schuler was surrounded by rock stars such as Pittman and AOL founder Steve Case, he must engineer this transformation with a less seasoned team. "A great majority of the managers here have only lived through a bull market," Schuler concedes.

Schuler, too, has a pretty entrepreneurial resume for someone running a $10-billion-a-year business. He joined AOL in 1995 when the company acquired for $35 million a multimedia firm he had founded. Before that he was CEO of a small software company. But what Schuler may lack in experience he makes up for in sheer enthusiasm, and his voice crackles with energy as he outlines how AOL aims to, first, sell users broadband and, second, sell them a host of premium services that only make sense over a big fat data pipe.

Here's how he envisions that future: Imagine a customer who pays AOL $24 a month for the basic subscription, plus around $30 a month for broadband service. Once AOL has hooked him on a high-speed, always-on connection, it can then persuade him to pony up another $30 for a special "family plan" that lets the whole household use AOL at the same time. They might even create a home network to link their computers and other devices to the Internet. That sounds techie, but as Schuler begins to describe the services the network would make possible, it starts sounding downright consumer friendly. Think about music: AOL is working with Sony to develop stereos that interoperate with the Internet--once Dad hooks one of them into the network, he'll be happy to pay another $20 a month so that he can download unlimited jazz onto the stereo's hard drive. The kids will spend another $15 ordering up interactive games they can play against each other on their networked PCs or against other teens on the Net. And since everyone's connected to the Net, they'll pay another $40 a month for unlimited voice and wireless calls carried via the Web's packet-switched network. Start dreaming like this with Schuler, and pretty soon you're closing in on $159 per month.

Yup, the vision is dandy. Executing it will be another story.

Start with the very first goal: getting customers to pay AOL $30 a month--on top of the basic subscription fee--for broadband service. AOL is off to a slow start in broadband. That's partly a reflection of a balancing act the company has to manage. Narrowband service over ancient telephone wires is a high-margin business. Broadband service is not: The head-end and central-office equipment that make broadband fly have been installed, expensively, over the past few years, and many new customers require a "truck roll," a visit from an installer. So while consumers think $40 or $50 a month is a lot to pay for high-speed service, it's actually an artificially low price designed to woo early adopters. Despite all that, no one at AOL will deny that the future is in broadband. And while somewhere around 10.5 million U.S. households now have high-speed access, Morgan Stanley estimates that just 400,000 pay AOL a monthly fee for broadband service. The rest--including some 1.6 million AOL subscribers--buy their high-speed connections from someone else, mostly cable or local-phone operators.

A healthy portion of those ten million others are getting their service from Time Warner Cable, the nation's leading broadband supplier--so the money is going to AOL Time Warner, if not to the AOL division itself. But Time Warner Cable passes just 20% of the nation's homes, and the narrowband customers AOL will need to convert live all over the country. That's why AOL Time Warner's recent failure to buy AT&T's cable assets seems dire. Says Ford Cavallari of Adventis, a Boston-based technology consulting group: "I think this is a mortal wound for the company."

It may have been self-inflicted. According to people familiar with the situation, when the bidding for AT&T's cable operations began, AOL Time Warner executives seemed somewhat divided in their commitment. While AOL Time Warner management finally did unite behind its bid, Comcast prevailed in acquiring the assets for $72 billion. Dick Parsons, who is slated to become CEO when Jerry Levin steps down in May, denies that management was in disagreement about making a bid for the assets.

The Comcast victory only strengthens the hand of longtime AOL rival Microsoft, which will own a big stake of the new AT&T/Comcast (and whose own online service, MSN, says it signed up more new customers in the fourth quarter of 2001 than AOL, for the first time ever).

But missing a step in the MSN vs. AOL race is only part of the problem of losing the bid to Comcast. The real failure is that instead of controlling the last mile into almost half the homes in the U.S., AOL will have to rely on tricky alliances to deliver broadband in areas not covered by Time Warner Cable.

Here's why: The AOL unit does not actually own any of the phone lines or cable wires running into its customers' homes. So the $30 Schuler talks about charging a customer for broadband service is money that AOL somehow would divvy up with the company that owns the wires. AOL is the marketer, the retailer, the front end. And that's exactly what it wants to be, since that gives it the customer relationship that will presumably lead to all the other broadband add-ons, from home networking to music and voice calls.

AOL Time Warner's divisions are notoriously independent, but Schuler says his AOL unit is working closely with Glenn Britt's cable division, whose Roadrunner broadband service is the market leader. When either Roadrunner or AOL captures the customer, the building block is in place to sell the rest of Schuler's broadband menu. The two divisions are working toward a common goal: to ensure that AOL Time Warner makes as much money as possible from every broadband customer.

More tricky is for Schuler to convince telcos and especially other cable companies that they, too, share a common goal. He has to convince them that they'll sell far more broadband connections by backing the AOL brand than they could sell on their own. But negotiating with other cable operators is a prickly process that has blown up in the past. Back when AT&T tried to expand the reach of its cable operations, it trumpeted a big alliance with Time Warner Cable that never materialized, souring feelings between the two companies. Now AOL faces the prospect of sitting down with Comcast execs and former AT&T guys--a group closely allied with Microsoft--to decide how to divide any and all monthly charges that ensue from AOL customers. That should be fun to watch. Despite their recent woes, AOL executives have lost little of their characteristic brashness and are described by telco execs as a nightmare to negotiate with. The good news on this front is that Parsons, a well-liked executive who led the AOL-AT&T negotiations, will impose his considerable diplomatic skills on the process.

But even if AOL succeeds in winning access agreements, it faces a huge challenge in getting customers to spend $159 a month on AOL. The proposed bundle of local, wireless, data, and video services is reminiscent of AT&T's recent aborted efforts to serve up big telecom bundles. Bundles are hard work. They can be tough to sell, they create billing challenges, and, in the case of voice services, they pose technological challenges that haven't been entirely worked out.

Not surprisingly, AOL executives blanch at comparisons to AT&T. AT&T "didn't have a base to build on, and it had a one-way relationship with the customer," Pittman says, despite AT&T's 60 million consumer long-distance customers. "We have an interactive relationship where you can talk back and forth to the customer."

How this supposed conversation translates into revenue is utterly unclear. And AOL's convergence plan--and the consumer price tag--do sound outrageous. But at least one would-be competitor is keeping his eyes peeled. Says Verizon CEO Ivan Seidenberg, whose core business would be attacked if AOL started selling phone service to its broadband customers: "There are no victims at AOL. These guys are tough, and they're smart. They are vulnerable, but you'll be the victim if you sit around too long while they focus on innovation and expanding their markets."

If he's right, if these guys are simply tougher and scrappier than everyone else in this tough and scrappy business, hold on to your wallet. After you've forked over that $159 a month, Pittman and crew will surely repeat their mantra: "See? We were right, and the critics were wrong."