By Debora Tidwell (TMF Debit)
ALEXANDRIA, VA (August 7, 1997)/FOOLWIRE/ --- America Online released their fourth quarter and year-end results after the market close on Thursday. The fiscal year has been full of challenges on many fronts. They were happy to report that they end the year as a much stronger and focused company and that they are growing their franchise in a steady controlled way, they are diversifying their revenue streams, they are controlling costs, they are retaining members at a record rate, and are continuing to widen the competitive lead.
ACCOUNTING ADJUSTMENTS. They thought the accounting issues were behind them. But, the staff at the SEC suggested that they make several changes to the results reported in the December and March quarters based on their new business model. After discussion and recognition of the need to move on, they decided to adopt those changes. As a result there are several timing adjustments that need to be explained. These are timing adjustments and do not impact the very good operating momentum AOL has.
INFORMATION PROVIDER PAYMENTS. The first adjustment relates to information provider payments. When they moved from hourly pricing to unlimited pricing, they had to renegotiate many of their IP agreements. They took a $25 million charge in the December quarter related to those renegotiations. The staff at the SEC felt it would be more appropriate to take that charge in the June quarter, since that is the quarter in which AOL signed all of the agreements. They have agreed to do this so the fourth quarter results are affected by the timing adjustment of this $25 million charge.
TELSAVE REVENUE RECOGNITION. In addition, the staff at the SEC requested that AOL remove and spread a portion of the revenue they recognized in the March quarter related to their commerce agreement with TelSave. They recognized $12 million of the TelSave $100 million in the March quarter. The SEC has requested that $7 million of this $12 million be recognized over time and AOL has reclassified that portion as deferred revenues. Although this change requires them to restate the March results, it actually has a slightly positive impact on the June quarter and future quarters as some of the revenue they originally recognized in March is now being recognized in June.
DISCUSSION OF CHANGES. Their view is that the accounting they used in December and March was appropriate and was consistent with generally accepted accounting practices. But, because they are building a new medium it is possible that people looking at the same facts can come to somewhat different conclusions. In the final analysis, they decided that the company was best served by getting these adjustments behind them and that is the approach they took.
IMPACT OF CHANGES ON QUARTER RESULTS. The bottom line is that they had an excellent quarter and if it wasn't for the negative and positive timing adjustments, they would have reported EPS of $0.09, above the consensus expectation of $0.07. Their revenues climbed to $476 million, largely driven by a nearly three-fold increase over last year in revenues from non-subscription sources.
CONTROLLED COSTS. They continue to hold the line on costs, particularly marketing expenses. Marketing expenses remain at just 20% of total revenues, well below their historic average. Their flagship online service resumed its steady, controlled membership growth; extended its competitive leadership; and built its non-service revenues. They demonstrated that they could expand member growth while improving access and the member experience.
SYSTEM BUILDOUT PROGRESS. They continued to make progress on their system build-out. All in all, they have added 150,000 modems since January and have expanded system capacity to handle more than 380,000 simultaneous users and monthly usage grew to 154 million hours. As they rapidly scale up the system they have also made progress in improving its reliability and availability. For example, they cut scheduled and unscheduled downtime by more than 2/3 to just 74 hours in FY1997. They haven't declared victory on access quite yet, they continue to take that issue very seriously and will continue to add modems at a rate of 20,000-25,000 per month. They also plan to complete the construction of their third data center this Fall.
MEMBERSHIP GROWTH. Nevertheless, they felt comfortable resuming their controlled, steady growth in membership. In the quarter they added more than 600,000 net new members, pushing them past 8.6 million members at the end of the quarter and putting them on track toward their goal of 10 million members by the end of the year. They have also continued to capitalize on the global growth of the industry and are on track to reach the 1 million mark in international membership by the end of the year. As they have increased membership they have also succeeded in holding down acquisition costs but also further improving member retention.
PROGRESS IN REVENUE DIVERSIFICATION. In keeping with their business model, they leveraged their strong membership base to continue their dramatic progress in increasing their revenues in advertising, commerce, and transactions. They have established the viability of their business model of increasing ratings through unlimited pricing and leveraging their growing base and usage to diversify revenue streams.
POLICY AFFECTING THE INDUSTRY. External developments favored them as well. The SEC decision on modem access fees and the Supreme Court decision on the Communications Decency Act removed major clouds from the horizon for them. They will continue to monitor these issues closely and take a more active role in shaping policy affecting the industry as well as exploring how to leverage the strengths of interactive services on the social policy front, specifically its ability to inform the public in a very personal way and to bring together diverse people with common interests.
ANS COMMUNICATIONS BUSINESS UNIT. ANS Communications is continuing to enjoy strong growth worldwide and that momentum was reflected in the launch of ANS Europe, the opening of 5 new sales offices in the US, and ANS' pending move to new headquarters in Purchase NY that could accommodate its minimum of 450 employees. ANS announced a strategic alliance with NYNEX, the first between a regional Bell operating company and a managed network services provider. Through this partnership, NYNEX will resell existing ANS services. ANS will support direct connections for NYNEX business customers over the ANS TCP/IP backbone network. The two companies will collaborate on select development and marketing initiatives. Fannie Mae announced that ANS has been chosen to supply remote network access for Fannie Mae's MorNet Plus network designed to reduce network charges and costs of originating a mortgage. Complementing its direct sales and alliance building efforts, ANS launched its reseller program designed to enable value-added resellers to sell ANS services. Delivering to the channel the most extensive offering in IP-based services, the program provides training and certification to support reseller capabilities and expertise.
AOL STUDIOS BUSINESS UNIT. AOL Studios has launched its premium WorldPlay game service and continued to cement its position as the leading content provider in cyberspace. AOL Studios' goal is to create valuable brands which it can apply to multiple platforms. For example, WorldPlay unveiled its new premium game service not just on AOL, providing AOL with yet another revenue stream, but also on AT&T Worldnet and Earthlink. On the Greenhouse front, ABC Television is developing a television special based on the unit's Christmas content sites and its home page. It is the first time consumer online programming has made the jump to television and the first such show from Greenhouse Entertainment Network Chairman Brandon Tartikoff. Digital City strengthened its position as the top locally focused online network by expanding to the Web with a Digital City Web Guide, a local guide of top US cities. They also entered into a strategic partnership with Realtor.com, the largest and most popular Web site for real estate information.
AOL NETWORKS BUSINESS UNIT. AOL Networks has widened their lead over the competition, underscored the unique strength of their brand, and are beginning to demonstrate the strong operating leverage and earnings potential of this business. Both their membership and member usage are climbing while they continue to build out their system and infrastructure to accommodate this increasing demand. They are building new revenue streams with groundbreaking partnerships with other world-class brands in advertising, marketing, commerce, and programming. They are lowering the cost of marketing while improving member retention. Their new programming lineup, next generation software, and innovative new products will weave the Web more seamlessly into their service while still making the service easier than ever for their members to use. Taken altogether, they will be able to continue to deliver the best and most convenient service while still making the service easier than ever for their members to use.
USAGE STATISTICS. Studies show that more leisure time is being spent on interactive services. As interactive services are developing into a mass-market medium, AOL Networks as the mass-market consumer brand in the Internet online world continue to reap the benefits with their unique advantages. They resumed steady, controlled growth with their membership increasing by more than 600,000 net adds by the end of the quarter. By the way, it is a traditionally slow growth period with only limited marketing. Even more striking, their member usage increased to more than 150 million hours in June, nearly four times last year's total for the month. By the end of the fourth quarter, their members were spending 5 million hours in more than 13.5 million sessions per day. Members averaged 38 minutes online a day, nearly triple last year's daily total.
THE HIGHEST RATINGS IN CYBERSPACE. That translates into the highest ratings in cyberspace. A recent PC Meter report, measuring usage of online services and the World Wide Web, found that 55% of all household time online was spent on AOL. 15 of the top 25 top-rated Internet and proprietary online sites on are AOL, with AOL email and AOL.com ranking #1 and #2. In addition, AOL sports, news, and entertainment channels each tripled the ratings of their nearest competitors including such familiar names as CNN, ESPN, and Disney. During peak usage hours, the number of their members online is hitting approximately the same levels as the quarter hour ratings of MTV and CNN.
INCREASED USAGE IS GOOD. This increased usage represents the ever-increasing popularity of AOL and is a critical goal of theirs. It is very positive for two clear reasons. First, increased usage means improved member retention. Members who are staying online longer are getting more out of the service and are more likely to stay with AOL. Member retention reached a two-year high in this quarter. Second, as they increasingly fulfill their business level, more usage translates into higher ratings and higher ratings mean that they are able to attract more high-quality marketing partners and higher advertising transactions and commerce revenues.
PARTNERS & ADVERTISING AND COMMERCE REVENUES. The quarter saw them continue their momentum in signing up world-class partners. When they announced the TelSave partnership, they promised that it would not be a one-of-a-kind deal. This quarter their advertising and commerce revenues alone grew more than 47% to $80.3 million. They demonstrated that, as the number one brand, with steadily expanding membership and growing ratings, they are going to attract the very best when it comes to online partners. During the quarter they signed or launched major advertising and commerce deals with CUC International, 1-800-Flowers, and Amazon.com. Not only are there more announcements in the pipeline, but they are rolling out in stages their marketing agreements with TelSave and CUC International. Their AOL branded long-distance telephone service with TelSave will offer members an attractive price and the convenience of online billing and customer service. CUC, shopping, travel, and other online services will gain prominent placement throughout various channels including an anchor tenancy on the old AOL shopping channel.
PROGRAMMING PARTNERS. AOL's premier position among mainstream online customers is just as important to programming partners. This quarter, AOL launched new or expanded partnerships with ABC News and ABC Sports and with CBS Sportsline. The reason is that advertisers, marketers, and content providers are discovering that if they want to establish a major presence online, it helps to be on AOL. That's why so many of them are willing to pay substantial fees to speak to AOL members. Their partners have also been one of the main reasons for AOL's success with holding down their marketing costs. During this quarter, member acquisition through co-branding efforts with their partners climbed by 150% over last year.
SERVICES, CONTENT, FEATURES, CONVENIENCE IMPROVEMENTS. They are dramatically upgrading their services content, their features, and the convenience to their members with the introduction of their new Fall programming lineup and the rollout of their next-generation AOL 4.0 software. They have an outstanding Fall programming lineup featuring easier system navigation, seamless integration of Web content, and fresh content that is actually shown at various times during the day. A key part of this new lineup will be AOL Today, a new multimedia programming guide to let members tell what is happening on the service around the clock.
INTERNET STRATEGY. During the quarter they also continued to advance their Internet strategy. They firmly established aol.com as a brand extension into the Internet. AOL.com and AOL NetFind are already established as major independent sources of advertising, marketing, and commerce revenues for the company. They also launched the beta test of AOL Instant Messager which makes AOL's Instant Messager Buddy List features available to Internet users worldwide. They are continuing to lay the groundwork for the rollout of AOL 4.0. It is in beta now and they will be introducing features and functions of this software in gradual stages later this Fall. Their efforts for fiscal 1998 are well underway, with major strides in all areas from member experience, to commerce, to their new Fall programming lineup and the rollout of AOL 4.0.
ACCOUNTING ADJUSTMENTS. Last October when they changed their business model they said they were also going to take a series of charges related to their move from metered to flat-rate pricing and from deferring marketing costs to expensing them as incurred. One of these charges dealt with the costs of terminating their agreements with their information providers which had become uneconomic under the new pricing system. They had to renegotiate these agreements because it no longer made sense to pay their information providers based on hourly usage or a high royalty percentage or a higher value per hour than that under their new pricing model. The cost of terminating these contracts came to around $25 million. The accounting principle involved here to determine the timing of the charge is whether expenses can be estimated and if the decision had been made to terminate the contracts, did it incur a loss. There was never any question that both of these conditions had been met for reporting the charge in the December quarter. They believed that taking the charge that quarter was not only appropriate, but required because the flat-rate pricing which made the terminations necessary occured in the December quarter. The SEC staff expressed a different point of view. The staff's view is that the charge should be taken in the quarter in which the termination agreements were actually signed. From an operating point of view, a key point is that they now have new, solid contracts that are appropriate for their business model and have resolved this issue in FY 1997. They are simply moving the charge from one quarter to another with no impact whatsoever on operations or full-year 1997 results.
The second type of adjustment relates to the TelSave transaction. During negotiations leading up to the execution of a definitive agreement, TelSave and AOL agreed that $7 million of the $100 million paid at signing would be fully earned upon public announcement of the agreement and AOL would have no further obligations to fulfill under the contract with regard to this amount. Thus, upon public announcement of the agreement, AOL believed they had earned the $7 million and therefore had a basis for recognizing it in the third quarter. However, the staff of the SEC took the position that the payment should be recognized over the 40-month term of the agreement, which they are now doing.
The third and last accounting issue relates to the classification of amortization of product development costs. This relates only to the classification and should be viewed as a geography item on the income statement. Historically, the company has included the amortization of product development costs in the product development line item in the income statement and has provided a very detailed analysis of the components of product development costs in the footnotes to the financial statements. The staff of the SEC has requested that AOL reclassify the amount of product development costs into cost of revenues. As a result, product development costs will be somewhat lower and cost of revenues will be somewhat greater.
FOURTH QUARTER RESULTS. Bottom-line reported EPS was a loss of $0.12. This includes the $25 million information provider charge they shifted from the second quarter to the fourth quarter and a $2 million benefit from restating third quarter results. When you back out the timing adjustments, they posted an operating profit of $10.9 million or $0.09 per share, which compares favorably to the Street consensus of $0.07.
SERVICE REVENUE. When they did the third quarter call, they mentioned that the gain in service revenue from that quarter to the fourth quarter would be modest, largely because of the fact that they scarcely grew their membership base in the third quarter and there is always a lag effect between registering members and receiving revenues from them because of the first-month trial period. Accordingly, fourth quarter service revenues came in at about $386 million or about $4 million greater than the third quarter. The modest increase in the June quarter was largely due to the ramping of net adds in the June quarter which grew each month. Members added later in the quarter contribute little or no service revenues. This also affects revenues per subscriber which, during the June quarter was $16.77 per member per month which compares to $17.02 per member per month during the March quarter. This difference is mostly related to, during the June quarter, generating lower 800-surcharge usage which is mostly due to their issuing credits as a result of distribution agreements with Packard Bell and an 800-usage number credit.
OTHER REVENUES. Other revenues came in as expected at $90.1 million, representing a 188% improvement over last year's June quarter of $31.3 million and a 31% improvement over the March quarter's $69 million on a restated basis. The largest, fastest-growing, and highest-margin component of this category is advertising and electronic commerce. This category includes merchandise, advertising, and transaction fees. These revenues increased 47% from $55 million in the March quarter to roughly $80 million in the June quarter. This translates to $3.47 per member per month during the June quarter, up 41% from $2.46 per member per month generated in the March quarter, as restated.
GROSS MARGINS. (Note: remember that they have reclassified product development amortization expense for software development into cost of revenues). As reported, June gross margins were 38.1%. Adjusting March for the reclassification, gross margins were 33.6%, so they improved by 450 basis points. As it relates to June, gross margins before reclassification was 40.2%, up more than expected from the previously reported 36.8% in the third quarter. While usage increased during the quarter, they realized greater network efficiencies, allowing them to drive down the cost per network hour by about 10%. They also saw the benefits of lower information provider agreements as they are now more in synch with the company's business model. In addition, they saw cost efficiencies in the call center operations, both as a result of improved connectivity, they saw lower call volumes and realized lower hold times. They eliminated the need for outsourcing and temporary services. Correspondingly, reclassifying product development amortization expense for software development costs cuts product development expense in the fourth quarter from what would have been 5.7% of revenues to just 3.4% of revenues. That shift in geography means that they will be reclassifying all prior periods, roughly speaking by about 2-3% of revenues and the product development expense in the future will be correspondingly lower.
MARKETING EXPENSES. Marketing costs came in at about $97.1 million or 20.4% of revenues, consistent with the company's expectations. Marketing spending has been and they feel will continue to be quite effective. Despite being both a transitional period for the business, coming off of the access crunch they experienced three months before and a seasonally slow period for new member acquisition, they added more than 600,000 new members on relatively low marketing spending. At the same time, they started co-branding AOL with great consumer products and brands. AOL is being distributed today in banks, at movie theaters, in cereal boxes, and at rock concerts, all in collaboration with their partners. They are also beginning to see nice results from Microsoft's Windows '95 bundling activies. AOL is also on the hard drive of just about every computer made for the consumer market including Packard Bell, Compaq, IBM, Acer, Gateway 2000, Dell, Toshiba, HP, and Apple.
G&A EXPENSES. They had expected G&A expenses to remain at March quarter levels as a percentage of revenues. Because of the modest growth in service revenues, they are up about 50 basis points to roughly 12% of revenues.
BALANCE SHEET. Cash appears on the balance sheet in two places -- under current assets cash and some short-term investments of $125 million and also under other assets restricted cash of $50 million. The $50 million represents a deposit they have with a bank under a collateral account that is pursuant to a credit facility that they plan to close very shortly. Comparing cash from the March quarter to the June quarter, one has to include both the $50 million and the $125 million to arrive at roughly $175 million in cash at the end of the quarter, which is down about $23 million. Also during the quarter, in connection with the credit facility, they borrowed $50 million. This $50 million as well as the reduction in cash in the quarter was used by the company to acquire equipment which they plan to refinance. Other accrued expenses and liabilities are up about $50 million due to increased business operations and some element of timing. The note payable is the $50 million borrowed. They also paid off $19 million, so the net increase in notes payable is roughly $31 million. Finally, with respect to deferred revenue, there are two components. There is a current component and a long-term component. In total, the variance in deferred revenue was about $15 million increase which is being driven largely by the cash advance from CUC being offset by the recognition of certain TelSave revenues that were previously deferred as well as the amortization and deferred revenue into revenue with respect to previously sold one- and two-year paid up subscriptions.
SUBSCRIBER COUNT. Their quarter-end subscriber count came in better than expected at 8,636,000 worldwide. They added during the quarter 600,000 of which roughly 525,000 was in the US and the balance of 75,000 was rest-of-world. That represents about a 39% growth in membership year-over-year and roughly a 45% growth in membership quarter-over-quarter. More significantly, they think it represents the kind of controlled, sustainable growth they set as an objective when they moved to their new business model last October. They accomplished this growth while holding marketing costs to about 20% of revenues.
CUSTOMER SATISFACTION METRICS. Key proxies they look at to measure customer satisfaction are usage and member retention. They continued to improve those scores this quarter. Usage continues to rise with this quarter coming in at about 18.5 hours per month compared to about 17 hours in the March quarter. They saw about 20 hours in the month of July.
USAGE PATTERN TRENDS. While there haven't been many particularly noteable shifts in usage patterns, either by time of day or type of content, the percentage of time their members spend strictly accessing the Internet via AOL continued trending down for the second quarter in a row. It was about 11% of total hours in the fourth quarter. It had been between 15% and 17% about a year ago. Second, there has been quite dramatic growth in the content area they call AOL programming, from under 2 million hours in the December quarter to more than 6 million hours in the latest period.
USAGE STATISTICS. In terms of usage, they reached more than 380,000 simultaneous users in the June quarter. That compares with 127,000 a year earlier and 328,000 at the end of the March quarter. Last week that number passed 408,000, a figure that exceeds the populations of such cities as Pittsburgh, Atlanta, and St. Louis. In the March quarter, AOLNet accounted for about 83% of their traffic. By the fourth quarter, that number had risen to 86%. Over that network they are now delivering more than 500 million page views per day, more than 220,000 message board postings, and over 350 million Web hits, 17 million pieces of email, and 160 million instant messages. Finally, with respect to member retention, in the latest quarter they realized the best retention they have seen in two years. They think this is a result of the improved member experience they deliver on AOL and the powerful value proposition represented by the product combined with unlimited pricing.
HEADCOUNT ADDED. During the quarter they added 175 employees, down from 1000 employees added during the March quarter. Substantially all the growth in the June quarter was in AOL Studios and ANS.
OUTLOOK. As it relates to the roughly $25 million charge for refunds in connection with the settlement, that proved to be a very good estimate and they have discharged substantially their obligation under that settlement. The amounts remaining are very minor. As it relates to cash flow, they do expect to be cash flow positive shortly. It could happen in the September quarter, although it is more likely to happen in the December quarter. They also think that the new customer adds will be less back-end loaded in the September quarter.
* 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.