FOOL CONFERENCE CALL
By Dale Wettlaufer (MF Raleigh)
UNION CITY, CA (February 9, 1997)/FOOLWIRE/ --- America Online reported second quarter 1997 results after the market close on February 6th. The December quarter is a hybrid, a period which included one month under the new business model of unlimited pricing and two months under the old pricing model. In addition, it is the first quarter in which they expensed acquisition marketing costs on an as-incurred basis. The results they posted are generally in line with Street expectations and the targets they set in October when they announced the new pricing plans.
RESULTS VERSUS PROJECTIONS. The financial statement targets that they set then were total revenues of about $400 million and they generated $409 million. Other revenue was projected to increase about 50% sequentially to a range of $55-60 million and they generated $58 million. They projected an operating loss before the restructuring charge of about $55 million which is what they did, or roughly $0.60 per share. The one target they significantly exceeded was customer additions. Their target for the December quarter was about 800,000 new customer adds, up roughly a factor of two from the prior quarter, and they added 1,240,000 or more than 3 times the number added in the September quarter and about 50% more than their planned 800,000. With respect to the restructuring charge, they said they expected it not to exceed $75 million and it came in at $74 million. (Note: There is also a below-the-line item charge of about $24 million in connection with the agreement with the attorneys general to provide customers with a refund or credit that is detailed below.)
ONLINE SERVICE REVENUE DETAILS. Online service revenues were up 56% over last year's comparable quarter and up about 13% sequentially. The increase in the quarter is due principally to an increase in the average number of AOL members of about 13% and a comparable revenue capture per member per month. It's important to note that the total AOL membership increased 19% in the December qaurter, but much of the increase came during December (over 500,000 net adds) and these were non-paying trial members in the December quarter. They added 1,240,000 new members, of which about 1.1 million were in North America and 140,000 were in Europe. The target they set in October with regard to revenue capture per member per month was for it to be comparable with the September quarter which was $16.86. In the December quarter, they beat that slightly. The revenue capture was $16.95. As they expected, the conversion rate from trial to paying members and the retention rates with respect to existing customers did improve during the December quarter with the introduction of unlimited pricing. Due mostly to access problems they are in the process of improving, retention did pull back somewhat during the December quarter.
OTHER REVENUES DETAILS. Other revenues, which include electronic commerce, advertising, network service revenues, etc., increased 136% over the December year-ago quarter and were up 50% sequentially to about $58 million. Most important, advertising and electronic commerce increased 66% even though online service revenues increased 13% sequentially, a substantial leverage opportunity to about $40 million as a category. Of this number, merchandise was about $26 million, advertising was up 150% to $11 million, and the balance represents transaction revenues. Another interesting way of looking at this is on a per-member basis. They captured almost $2 per member in the December quarter, up substantially from roughly $1.35 in the September quarter for these new and growing revenues. This is an area of strategic focus for the company. It represents significant opportunity, as they leverage their large customer base, and it contributes very high-margin revenues to the company business models. The remaining $18 million of this category includes ANS network revenues and other marketing related revenues including the AOL-branded Visa card which is seeing great success in the marketplace.
MARGINS. Gross margins declined from about 46.2% in the September quarter to about 40.1% in the December quarter. As they were rolling out unlimited pricing and still carrying a fair amount of traffic on a costly variable network, they did expect margins to drop substantially. Given the much higher-than-planned customer add number, and because of the large up-front cost to support a new customer including free trial and customer support, they would have expected a lower gross margin than they posted. This is an important point -- in the gross margin number they absorbed millions of trial hours and many calls without generating any revenues in the December quarter. Of the roughly 620 basis point difference in gross margins, about 250 basis points is due to data time cost, about 200 basis points is due to customer support cost, and about 100 basis points is due to higher merchandise costs. This is to support a much higher merchandise revenue number that is growing faster than total revenues.
USAGE INCREASES. During the quarter, hours increased by about 62% (this is data time or packet net hours) to roughly 215 million, while they realized cost efficiencies moving more traffic to AOLNet. In fact, during the quarter about 77% of their traffic was on AOLNet. That's up from 69% in the September quarter. Their cost per hour dropped in the quarter by about 20% and they expect to see these cost efficiencies going forward. During the quarter, they scaled the systems to increase the number of simultaneous users by 72% from 146,000 simultaneous users in September to about 250,000 in December. It is important to highlight that this rate of scaling has never been done by anyone else. In terms of hours of usage, it increased from about 7 hours in the September quarter to a little more than 10 hours and is now running about 17 hours across the customer base.
OTHER GROSS MARGIN IMPACTS RELATED TO PRICING CHANGE. In preparation for unlimited pricing, they ramped their call center operations by about 200 staff and also added several hundred outsourced reps. In addition, voice telephone calls surged as they registered record numbers of new customers and incoming calls requesting information about their service and new pricing and also addressig the connection issues also increased. As a group, that represented about 250 out of the roughly 620 basis points variance in the gross margins.
Given that the marketing program had been committed when they introduced unlimited pricing and they are expensing marketing costs for the first time, they expected marketing costs as a percent of revenues to be unusually high -- roughly 35-40%. These calls came in at the low side of this range at 36%. Going forward, they expect the pull-through demand of their product to help them keep marketing costs relatively low and also to fund the increased costs of providing unlimited pricing.
PRODUCT DEVELOPMENT. Stepping through the P&L, product development costs increased by about $2.3 million sequentially and stayed relatively flat as a percentage of revenues at a little more than 5%. There is no interesting data point in that area.
G&A HIGHLIGHTS. G&A costs were higher than originally expected. As a percentage of revenues they increased from 2.2% in September to about 11.9% in December and about $13 million. About half of the increase is due to either one-time charges like executive office relocation, severance payments, or costs associated with the proxy and the listing on the NYSE, or costs due to expansion which they will support for growing revenues. They opened three advertising offices during the quarter. They also opened the Albuquerque call center and expanded various Digital Cities locations and moved into expanded new offices in the Dulles headquarter operations. Over the next quarter or two they expect G&A as a category to be about 10% of revenues and then begin trending down a little as they grow into the capacity in infrastructure they invested in this quarter. Related to other expenses, they included a charge of roughly $4 million for the write-off of various technology licenses and a node to a production shop that will not be realized. Before these charges, other income would have been about $3 million.
RESTRUCTURING CHARGE. As they move to a new business model, a new pricing plan, they announced in October that they retained a restructuring charge of up to $75 million. The final number came in at about $74 million. It includes roughly $25 million due to the restructuring of various information provider agreements. This is due to the fact that they moved from a usage-based business model to a membership-based business model and, as a result, their revenues per hour (the basis for how they paid information providers) had to be renegotiated. They are asking their information providers, in addition to payments from AOL, to join them in freeing up inventory created in their area that they can jointly or individually sell against advertising. They also shut down the GNN operations which are really subsued in the new AOL Internet online service with unlimited pricing. There were various facility closing associated with that strategic move including Barrow, Berkeley, and Santa Barbara operations. That is roughly $17 million. In addition, there were various obsolete marketing materials and other costs associated with the price changing including communications which aggregated about $17 million. Through the restructuring, they terminated about 300 positions which translates to about $9 million. The remaining $6 million represents amounts which individually are not significant.
CHARGE RELATED TO ATTORNEYS GENERAL SETTLEMENT. This charge is estimated to be about $24 million. It is based on roughly 6 million eligible members. To be eligible you had to be a paying subscriber in either December or January and then a further subset of that, because if you used more than 15 hours you were not eligible for the call-in reques refund. They also used request rates of about 15-20% for those calling in and about 3% for those who will be writing in. That brings the average to about a $24 refund per request with roughly 1 million requests. Based on early results they believe, and also historical precedent in these types of areas, the $24 million settlement charge they are accruing for in December will be adequate. The rationale for including it in the December quarter is that it is related to an event that surfaced in the December quarter and is a below the line charge because it is in connection with the settlement.
BALANCE SHEET HIGHLIGHTS. Cash and short term investments increased from $102 million at the end of September to about $130 million at the end of December. This is driven largely by the receipt of a large number of fixed renewals under the one- and two-year prepayment plans. You will see prepaid expenses increase from roughly $70 million to $91 million. This is due to the timing of marketing activities at year end and also higher value merchandise that they are now carrying in inventory and are selling through the AOL merchandise store. The next material variance within the asset category is a reduction in goodwill of about $10 million and that is due principally to the write-off of G&A goodwill.
Stepping through the liabilities, there is an increase in other accrued expenses in liabilities of about $120 million. Of that, roughly $62 million is due to the restructuring and settlement charge and roughly $33 million is due to telecommunication accruals which tracks the increase that they are seeing in terms of usage and the overall business volumes. Then the final item of material variance is deferred revenue. They announced when they rolled out the new pricing that they would be seeing deferred revenues increase for two reasons. One, they would be selling advanced renewals and they would be deferring a larger number for the membership portion of the fee which is now $20 versus $10. Also the $50 million increase, which is the deferred revenue current liability piece and the $5 million deferred revenue long-term, the $50 million is due entirely to the advanced payment and also deferring revenue of the membership fee.
WHERE THEY STAND WITH REGARD TO OTHER PROJECTIONS. The company was asked where they stand with regard to projections made about the next few quarters. As relates to the underlying operations for the March quarter, they do plan to be break-even. There are some incremental investments that are needed to meet the demand and that will cost between $10-15 million and they expect that to drop to the bottom line in the March quarter. For June, they expect to be on track both in terms of revenues and bottom line. They ended the quarter with roughly $130 million in cash. They are seeing people continue to take the one- and two-year advance renewals even though they haven't been marketing those. When they announced the advance renewals in October, they said it probably would be around $70 million or so. As they mentioned, they realized about $30 million in the December quarter, so in the March quarter they will likely see at least another $30 million and it could be higher than that. In addition, when you look at the company's P&L, it will track cash very closely. So, to the extent they see a $10-15 million loss in March due to the building out or renting of modems, that will translate pretty much to cash. Then as they move to profitability in the June quarter, that will translate to positive cash as well as cash from continuing to sell, and at that point hopefully more aggressively, the one- and two-year paid-up subscriptions. They set targets of between $70-80 million for non-subscription revenue capture in the March quarter and they are very comfortable with that and expect to see a nice sequential increase in the June quarter as well, particularly as they see advertising ramping as well as leveraging the increased usage through premium rate cards for advertising.
OPERATIONAL OVERVIEW. Obviously the quarter was an extraordinary period for AOL as they experienced unprecedented demand. Their top priority right now is dealing with the resulting access problem. That is why they are working day and night to fix the problem as quickly as possible and to maintain member loyalty through this transitional period.
FIXING ACCESS. The short take is that they are on target with their business plan, they are accelerating their system build-out to fix the access problem faster, and that because of all this they feel good about their ability to satisfy the needs of their existing 8 million members. They are confident they will reach 10 million members by the end of the year and will do so profitably as they successfully shift the business model toward new revenue streams.
RENTED MODEM CAPACITY. To accelerate their solution of the access problem, they were delighted to announce that they have secured rental agreements with outside suppliers for an additional 50,000 modems which they will start bringing on-stream later this month. The additional rented capacity, together with their $350 million build-out of AOLNet, should help make 350,000 modems available to their members by the end of April, two months ahead of schedule. This is an increase of 150,000 modems since the beginning of January which they expect to translate into an additional 6 million daily member sessions or about 16 million a day overall.
RENTAL GIVES THEM FLEXIBILITY GOING FORWARD. They will continue to build out their own more cost efficient private network as scheduled through June. The additional rented capacity will give them a cushion should demand continue to exceed expectations or, with connection times restored to normal in their basic $19.95 service, it could give them added flexibility to offer additional premium services to businesses or to other users. Modem capacity is scarce and there are a number of outside factors that constrain them from building out AOLNet any faster. That is why they have been negotiating to use the excess capacity other networks have on an interim basis. As an aside, the scarce availability of modem capacity is also a significant barrier to entry for potential competitors and for existing competitors to grow beyond where they are today.
ADDITIONAL NETWORK COSTS RELATED TO RENTALS. They will incur additional network costs as they use this additional capacity over the next few months. They will generally be paying for each hour of time used from these outside suppliers and they expect that to result in an increase in their March network expenses of about $10-15 million. But, this is money well worth spending to improve access more quickly and the additional cost will be temporary as the rented capacity will be phased out as soon as their AOLNet private network is fully deployed. By putting the demand issue behind them faster, they will be better positioned to take full advantage of the major opportunity that has crystallized for AOL over the past few months.
EXPLOSION IN MEMBER ADDS AND USAGE. During the last quarter they added a record 1.2 million new members, with more than 500,000 added in December alone. Even more dramatic was the explosion in usage. Members logged 102 million hours in December, more than double the 46 million per month average during the September quarter. Usage of their service is still rising, even as they hold their membership base at around 8 million for the time being in order to catch up to this extraordinary demand. Their members are currently logging on for about 10 million sessions per day and they ran up an extraordinary 125 million hours during the month of January.
GROWTH PROBLEMS, WHILE SERIOUS, HAVE A BRIGHT SIDE. This means that while they have a problem meeting demand over the short term, and they don't underestimate the seriousness of that problem, they also have taken a major step forward in achieving two important long-term goals. First they are cementing AOL's position as a dominant brand in Internet online services. Second, they are laying the foundation for sustained profit growth through a multiple-revenue-stream business model. Their experience over the last 3 months has demonstrated, beyond even their own most aggressive expectations, that the Internet is rapidly becoming a mass-market medium. It has also demonstrated that AOL is at the very crest of this wave. While the surge in demand is largely attributable to their new pricing scheme, it is important to note that the growth in AOL membership and usage actually took off in October, more than a month before the flat-rate pricing went into effect. This reflected not only some anticipation of the price change which was announced at the end of October, but also the success of the new 3.0 software in improving the member experience and the effectiveness of their stepped-up marketing efforts to position AOL as the vehicle of choice to reach the Internet. Moreover, during the quarter they continued to reduce churn and improve conversions of trial members. They also started to see old AOL members come back.
WHY WERE ACCESS PROBLEMS SUCH A SURPRISE? They have been asked why they didn't see the surge in demand coming. In fact, they did test price structures including the 20/20 plan which they made available last June and, while those tests had indicated that a flat rate would be well received, it didn't reveal anything like the growth in demand that has resulted. In anticipation of the move to unlimited use pricing, they have been steadily increasing system capacity, adding approximately 60,000 modems to AOLNet in the second half of last year. They did expect some peak-period congestion when they made the price change and they warned their members that was likely. But, again, based on their tests, they felt strongly they could keep this to a manageable level through their continued system build-out. Obviously, despite their preparations, they have not succeeded in making the transition to flat-rate pricing a smooth one.
FOCUS NOW IS ON FIXING ACCESS PROBLEMS. But the good news is that the current demand for AOL has demonstrated beyond a shadow of a doubt that they have developed a compelling product that is not easily replaceable. Members truly are saying they need AOL. But they are also saying they want to see the modems, and that is what AOL is focused on doing. They believe it makes good business sense to put improving service ahead of new recruitment efforts and accelerate their expansion to improve service faster. Once they improve access, they believe they can win back AOL members who may have left the service for that reason.
LEVERAGING AUDIENCE REACH FOR NEW REVENUE STREAMS. Now that they have reached critical mass in terms of audience reach, they have begun leveraging their success by building the alternative revenue streams that are at the heart of their new business model. They are seeing very strong progress in the advertising and electronic commerce revenues. Based on their increased membership and usage, they believe they have the ratings now to convince advertisers that they need to be part of their advertising mix. That is backed up by a just-released Nielson study which showed that AOL households watch significantly less television than the national average. The Nielson ratings will start to show an impact on advertising revenues in 1998. They feel we are at the early stage of a migration of advertising online and AOL is well positioned to be the key beneficiary of this trend. On the electronic commerce side, they had a record Christmas season and just announced a partnership with Barnes and Noble to open the world's largest online bookstore, and more such deals are on the way. The unlimited pricing structure has a big impact on electronic commerce because while before people viewed the service as something where they were being asked to pay $3 an hour to browse in an online mall, now with unlimited pricing they don't feel that constraint and they take advantage of it to shop online. Also on the way are exciting new programming and features including Casablanca, their next generation software, and Driveway.
ANS COMMUNICATIONS. ANS is continuing to grow its revenues by meeting the connection needs of large and mid-size businesses. ANS is playing the leading role in their 75% expansion of the AOLNet network during the next five months. It is also doing internal beta testing of the US Robotics X2 technology and plans to open that trial to external users in the near future. They want to make sure the technology is scalable in a reliable fashion to meet the needs of their 8 million customers before they make a decision to roll it out beyond the internal tests. They are very pleased to note that ANS recently earned Data Communications prestigious Hot Product of the Year Awards for its market-leading virtual private data network and Web hosting services.
AOL STUDIOS. AOL Studios and its operating units Greenhouse, Digital Cities, and Imagination Network manages more than 50 original programming titles, properties, and channels that have all seen their AOL usage soar as a result of their move to flat-rate pricing. With venture capital investments like the Motley Fool and PlanetOut as well as new media brand partnerships like the Style Channel with ABC, Greenhouse is continuing to build existing brands, acquire undervalued properties, and purpose established content studios. Digital Cities has experienced steady advertising growth due largely to the introduction of seven new cities including Dallas, Denver, and San Diego. Just recently Digital Cities purchased the producers of Total New York, an online guide to the city. Finally, Imagination Network is about to premiere CyberPark, a 3D community with interactive games, entertainment, and social activities. CyberPark will be carried on AOL networks and other ISP partners they will announce later. That will give CyberPark the broadest Internet online distribution of any multi-player game and entertainment platform.
AOL INTERNATIONAL. Their total international membership now exceeds 500,000. They are enjoying strong member growth in Europe and recently launched in Austria and Switzerland to extend the effort they already had underway in Germany, France, and the United Kingdom. Their Canadian service continued to expand as well as they had more Canadian content. They are gearing up in Japan for a Spring launch with their partners there.
EXPANSION SPECIFICS. The 150,000 modems slated for deployment in the first four months of this year is quadruple the number they had in all of AOLNet 1.5 years ago. By the end of April they plan to be able to accommodate more than 400,000 simultaneous users, again quadruple the amount they handled just one year ago. With the accelerated system build-out, AOL's member-to-modem ratio will be reduced to 20-to-1, down from 40-to-1 before they launched flat-rate pricing. They think usage will probably normalize to some extent over time as the unlimited usage novelty wears off. They expect the major uptick in usage they have seen is about what they will see -- in the range of 15-18 hours average -- when the dust has settled. They also emphasized that while 20-to-1 seems high for services like ISPs who target heavy users, AOL with 8 million users has a more mainstream audience. They will also break ground soon on their third data center, a 180,000 square foot facility that will double the data center space for their host computers dealing with the network side of the equation.
SHIFTING VIEWERS TO NON-PEAK HOURS THROUGH CONTENT. On the demand side of the equation, they are examining all of their programming to find ways to move users to non-peak usage hours. All AOL content, not just things like chat and games saw increased traffic in almost equal proportions. That is extremely promising for advertising and their multiple revenue stream business model. They also recently instituted a 45 minute timer which reminds people how long they have been online and logs them off if they don't respond within ten minutes. The timer is already helping them free up modems to get more people online. While the hoarding factor, people staying online to avoid difficulty logging back on, is a small percentage of usage, every little bit counts. Third, they are developing new features like Driveway, their own technology that provides convenience for members while easing the pressure on their system. Driveway will be a preview this Spring on AOL. Meanwhile they are also building the member support team.
COMPELLING DEMOGRAPHICS FOR ADVERTISERS. They made substantial progress building advertising and electronic commerce revenues and they believe that AOL is now the leading advertising vehicle on the Internet. AOL has doubled its ratings in the last 90 days which means they have over-delivered to the advertising community by a factor of two. They also believe that advertisers are significantly under-delivering to AOL's highly desireable demographic and they are redoubling efforts to take that message to advertisers. During the same time period, AOL commerce partners also found that their dramatic increase in usage had a strong positive impact on their online marketing. In terms of programming, they brought Rolling Stone online and launched a new area with David Letterman and continued to break attendance records at AOL live events. Tuesday night's chat with Rosie O'Donnell made history. They broke the record for Internet's largest chat with 16,818 members chatting simultaneously.
COMMUNICATING PROGRESS TO MEMBERS. They have launched new TV and print advertising regarding what they are doing to fix the access problems. They are going to continue to keep members up to date on their progress and communication is a key part of this process.
* A Fool conference call synopsis represents an effort to highlight the salient points of a conference call and should not be taken as an authoritative accounting or transcription of the entire event. Note: Statements made by a company other than historical information may constitute forward-looking statements for which the company can claim protection under the Safe Harbor Act. Please consult the company's filings with the SEC for information on risk factors which might cause actual results to differ materially from the information contained in these forward-looking statements.