By Debora Tidwell (TMF Debit)
ALEXANDRIA, VA (November 7, 1997)/FOOLWIRE/ --- America Online released their first quarter 1998 results after the market close yesterday. Steve Case reminded everyone that this is the first anniversary of the announcement of their new AOL initiatives. A year ago they identified a number of ways they thought they could enhance their position in the market, including switching to flat-rate pricing, shifting their marketing focus more to retention, developing a multiple revenue stream business model that relied more heavily on advertising and commerce, improving the member experience for existing AOL members with version 3.0 and for new members with a better introduction to the service, and restructuring the company into 3 businesses.
MEMBERSHIP GROWTH. Looking back, their efforts are beginning to pay off. The momentum they have seen in the last quarter underscores this point. During the quarter, their worldwide membership increased by 821,000 members to a total of 9.4 million members and it looks like the current quarter will exceed that. A lot of that growth came from improved member retention. They established a goal of reaching 10 million members some time ago and it now looks like they will pass the 10 million mark this month, ahead of schedule.
USING BRAND STRENGTH TO CONTROL COSTS. While growing their membership, they used the power of their brand and key partnerships to control costs. They continue to sign multi-year agreements with leading interactive marketing partners. On the international expansion front, they announced the launch of AOL in Australia. They expect the Compuserve transaction to close in the March quarter and are working to make the transition as smooth as possible.
Q1 RESULTS. They posted net income of $0.16 per share on a record $522 million in total revenues, a 49% increase over last year's $350 million in total revenues. Their earnings this quarter included a $0.04 per share benefit related to Excite.
ACCESS IMPROVEMENTS. They are continuing their aggressive buildout of AOLnet and have more than 680,000 modems available for use. They have upgraded over 75% of AOLNet to support the new 56K modem technology. Last month they exceeded 500,000 simultaneous users.
RATINGS CLIMB. Their ratings showed a steady increase over the last quarter. Members worldwide spent 173 million hours per month online compared to 149 million hours per month during the previous quarter, a 16.5% climb.
MARKETING EXPENSES FLAT. This is really the first quarter in which they have been able to clearly demonstrate their ability to get high subscriber growth levels and yet prove that the marketing costs are really part of their fixed costs rather than part of their variable expenses. They kept marketing expenditures essentially flat by relying more on AOL's brand strength and their co-branding marketing with key partners. Their total marketing expenses fell from $150 million last year to $97.8 million.
BRAND STRENGTH. AOL's brand now is stronger nationally than any of the regional Bells, GTE, or Cellular One, even in households with high usage of cellular and paging. This brand strength resulted in deals that grew advertising, commerce, and merchandising revenues 144% over the past year. They had more than $80 million in new advertising and commerce deals that started this quarter, yet they recognized less than $5 million of that total. At the end of September they had a backlog of signed but not yet recognized advertising and commerce deals worth $224 million. That is more than a $40 million increase over the June quarter and a more than tenfold increase over the year ago backlog of $20.7 million.
MULTIPLE REVENUE STREAMS. Today, AOL is the only company in the Internet online space that has both meaningful subscriber revenue and strong advertising and commerce revenue. They are developing an additional revenue stream with merchandising and retailing. Now exceeding $100 million in annual revenues, this business is becoming comparable to good-size catalog companies.
RECORD PROFIT MARGINS, STRONG CASH FLOWS. They had 13% growth or $48.6 million in service revenues over the June quarter levels. Profit margins, as a result of greater efficiencies in marketing and their cost of delivering the service, hit record levels. They generated strong cash flows during the quarter and raised their cash balance to $229 million from $175 million at the fiscal year end.
RECORD REVENUES. Revenues for the quarter set new records, increasing 49% over the same period last year to $522 million. That is also 10% better than the June quarter. With cost of revenues being reduced by about 90 basis points to 62.7% in the quarter and with significant efficiencies in marketing, marketing costs were lower by 190 basis points to 18.7% of revenues. Their pretax profit margin increased 300 basis points, from 2% before a contract termination charge in the June quarter to 5% in the September quarter.
THE EXCITE BENEFIT TO EARNINGS. Street consensus on earnings was $0.12 per share. They came in at $0.16 per share including a $0.04 per share favorable impact from their operating relationship with Excite and sale of some Excite stock. Of the $0.04, $0.02 is in operating revenues and the other $0.02 relates to the sale of some Excite shares in the September quarter which is recorded as other income. They will be recognizing a $19 million gain related to Excite over 5 years which will be included in other revenues. Given that there is a recurring nature of these revenues and they are operating, another way to look at their EPS this quarter is that it was $0.14 from operations.
CASH. A major development this quarter was the strengthening of their financial condition and specifically their strong cash flows. Cash provided by operations, which excluded financing and investing activities, was $79 million and they maintained their liabilities at roughly the same level despite a 10% increase in business volume. The $229 million of cash will be augmented by approximately $225 million in cash they expect to receive as part if the Compuserve transaction.
MARKETING TO ADD NEW MEMBERS. They invested $98 million or 18.7% of revenues adding 821,000 new members. By comparison, in the previous quarter, they spent 20.6% of revenues or $98 million (same amount) on marketing but added only 600,000 new members. The more stark contrast is with a year ago. This quarter versus FY 1997 first quarter they spent 35% less in marketing adding 98% more in net new members and supported a subscriber base that is 41% larger.
SERVICE REVENUES. One of the consequences of steady growth and strong customer retention is a healthy growth in service revenues. On a per-member basis, service revenues rose to $17.37 per month compared to $16.86 in last year's first quarter and $16.67 in the June quarter. This is better than expected. 746,000 of the quarter's new members were generated in North America and, as such, are revenue generating. That is 68% more than in the June quarter. Strong service revenue and revenue per member trends should continue.
OTHER REVENUES. Other revenues climbed 125% over year-ago levels and were down slightly from the June quarter due to lower merchandise revenues. The advertising and electronic commerce component of other revenues in the September quarter, excluding merchandise sales, was flat compared to the June quarter. Even though they recognized $6 million less in revenues from their agreements with CUC and Telsave, offsetting this variance was a 34% increase in advertising and commerce revenue other than from these two contracts.
OTHER REVENUES LESS THAN EXPECTED. Other revenues were less than expected as a result of several factors. First, merchandise revenues were lower as a result of their decision during the quarter to temporarily suspend telemarketing activities and a reallocation of refunds and credits from all their service revenues to merchandise revenues, which is based on a refinement in their reporting of refunds and credits associated with merchandise sales. To quantify this impact, merchandise revenues were about $11 million less in September versus June and a great amount less than expected. They expect December quarter merchandise revenues to resume growing from June levels.
ADVERTISING DEALS. Second, even though advertising revenues other than Telsave and CUC increased 60% from June to September, they focused on and signed several large multi-year contracts. While these deals are strategic in that they lock in advertisers to AOL and provide a backlog of signed and to-be-recognized revenues, they are structuring these deals more conservatively and, as a result, are recognizing less amounts in the near term. During the September quarter they began operating under contracts with a value more than $80 million but only recognized $4.5 million from such contracts. The trade-off is more revenues to be recognized in future periods. While they continue to focus on the larger strategic deals, their objective is to have a mix of business that is complimentary and allows us to continue to build a strong backlog while recognizing near-term revenues.
GROWTH IN OTHER REVENUES DEFERRED ONE QUARTER. When you take all this into consideration the result is to defer, by about 1 full quarter, their growth path for other revenues. But, as you adjust your models, the impact of this change should be offset by greater than anticipated growth in service revenues and better than expected margins.
MORE DETAILS ON EXCITE SHARE GAINS. In November 1996 they entered into three agreements with Excite providing for the sale of Webcrawler to Excite and an agreement for AOL to provide carriage for Webcrawler and a 5-year license agreement under which they license technology from Excite that they use in NetFind. In connection with these agreements, they received 1,950,000 shares of Excite. As this transaction regarding Webcrawler was finalized in March 1997, they valued the shares at the then current price of $11.70. Given that they had a cost basis of about $3 million in the Excite shares, the total gain to them is about $19 million. Given that they have certain performance obligations under the 5-year license agreement and to be conservative, they are spreading the $19 million gain over 5 years. Since this relates to operations, such amounts will be recorded as other revenues. Any gain upon the sale of Excite shares for a price in excess of $11.70 will be recorded as other income. During the quarter they sold a little over 245,000 shares at an average price of $28.54. They still hold 2.6 million shares of Excite with a cost basis of $26 million. So, at the end of September at the price of $28.50 per share, they have a $40 million unrealized gain.
OTHER EQUITY POSITIONS. With the value they bring to advertisers and those looking to partner with AOL for their carriage and marketing capabilities, they have been successful at obtaining significant low-cost equity positions in the companies with whom they partner. So, in addition to providing value added services for customers and getting cross-promotional marketing and customer acquisition benefits, they also are now getting warrants that allow them to participate in the upside potential of their partners.
EXPENSE RECLASSIFICATIONS. Beginning this quarter they made a number of refinements to the way in which they classified certain expenses. For example, facility costs had been previously classified as general and administrative expenses and are now classified in the expense category based on the expense benefitting from the expense. Facility cost for the marketing group that used to be recorded as general and administration costs are now expensed in marketing. As a result, they have reclassified certain prior period expenses to ensure comparability. There is no bottom-line P&L impact, this is a reclassification of expenses. There will be some ongoing adjustments like this, but probably not as large as this quarter.
COST OF REVENUES. With service revenues increasing 12.6% and higher margin other revenues declining 3% from the June quarter, they were able to manage cost of revenues down to an 8.1% increase. This was achieved as they realized cost efficiencies from the growing scale of their network operations. The cost per network hour was about 10% lower in the September quarter than in the June quarter. During the quarter they continued to manage traffic to AOLNet which increased from 85% in the June quarter to roughly 90% in the September quarter. They also made significant investments in their services infrastructure, both in terms of people and equipment.
PRODUCT DEVELOPMENT AND G&A COSTS. Product development costs are down roughly $3.5 million from the June quarter and represent 3% of revenues versus 4.1% in the June quarter. The primary reasons are greater capitalization due to projects in process during the quarter and lower employee and employee-related costs. At the same time there is a sizeable jump in G&A costs from about $44.6 million in the June quarter to $54.3 million in the latest quarter. The largest single portion of the roughly $10 million increase is attributable to costs of amending certain stock option grants with certain ANS executives in preparation for the Compuserve transaction.
BALANCE SHEET. The balance sheet was strengthened considerably during the September quarter with cash up $54 million and working capital up $48 million. In addition, they added $108 million to their stockholders equity. Other assets increased $33 million due to the increase in the value of their stock holdings of Excite of 2.6 million shares. The only other significant increase in the balance sheet is in notes payable which increased $28 million due to the refinancing of their Reston operations building.
* 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.