FOOL CONFERENCE
CALL SYNOPSIS*
By Jeff Fischer
(JeffF@fool.com)
America
Online
(NYSE: AOL)
22000 AOL Way
Dulles, VA 20166
(703) 448-8700
http://www.aol.com
ALEXANDRIA, VA (May 6, 1998)/FOOLWIRE/ -- Diversified online leader America Online reported third quarter fiscal 1998 net income of $39 million, or $0.16 per share, before special charges. Revenue climbed 54% from the prior year to a record $693 million, while advertising, commerce and other non-subscriber revenue reached a record $118 million. The company topped analysts' revenue and earnings estimates.
Conference Call Summary. Steve Case (CEO) opened by stating that operating income continues to improve while AOL is seeing continued strength and momentum with all of its main revenue streams. At the same time, the company is becoming more efficient (following a reorganization), and is beginning to leverage its business niche and customer base through several opportunities, many of them mentioned in this summary.
Steve Case offered the following thoughts on the company's new pricing plan, new organization structure (which accounts for CompuServe), and new leadership in Europe and international operations. Case said that overall AOL's business model is working very well, with subscriber growth, commerce and ad revenue all growing as well as or better than hoped for, while the company is controlling costs better than ever as well. Operating income before taxes rose to a record $63.4 million, or 9.1% of revenue.
New Pricing Structure. AOL's $2 increase in monthly subscriber fees has been well accepted. The fact that the company recently passed the 12 million member mark supports this. AOL saw less drop-off than might have been expected following the price increase. This signifies significant pricing power -- at least to a certain point, one can assume.
The $2 monthly increase in the unlimited usage plan was implemented in order to fund network improvements and to match the costs that those improvements (and increased membership use of the network) entail.
New Organization: The company has reorganized itself into three key divisions, and now the full resources of the company are standing behind its flagship AOL service, CompuServe, and AOL studios. Improved efficiencies and increased coordination and execution is resulting throughout the organization. AOL is now maximizing its 100% ownership of AOL studios, while CompuServe has already seen improved U.S. operations under AOL's guidance. AOL has stabilized CompuServe's customer base and improved profitability in the service. A CompuServe marketing campaign and a software upgrade are planned for the summer.
Improving the Member Experience. In an effort to continually improve the membership experience, America Online is constantly working to upgrade the service. The new AOL 4.0 version has been previewed and 1.2 million copies have, to date, been downloaded, while 30,000 more are downloaded per day. So far AOL has had great feedback on the new software. The company will continue to add new features for members, including several to the personal finance channel, which is the "most popular financial area in cyberspace."
AOL also plans to continue to improve the network. In April it launched the first high-speed HDSL system which promises to be the fastest service available. Even though today's broadband solutions are too expensive and complex for broad appeal, testing them helps find new solutions and AOL is fully committed to broadband.
Advertising and Marketing. Moving forward, a large initiative will be to provide advertising in a useful context -- for both the advertiser and the user. This means, of course, targeted ads.
Online Policy and Law. The aim of AOL is to build the interactive medium in a way that is fair for everyone. News related to this effort includes the Federal Communications Commission's (FCC) reconfirmation of the regulated framework for Internet services. AOL also made progress in achieving a tax moratorium for e-commerce. Congress, the Clinton Administration, and state governors have been contacted in hopes for a time out on state and local e-commerce taxes so that, in the long run, the tax laws on the Internet are simple and competitively neutral.
International copyright laws on the Internet are also forming. Internet Service Providers (ISPs) will not have copyright liabilities for normal operations, while AOL is working with IBM and Hewlett Packard to organize a privacy alliance in order to form industry-wide privacy standards.
Bob Pittman (COO) Speaks. The quarter saw across-the-board improvement for AOL, with sustainable quality earnings growth taking place. The multiple revenue streams are all chugging along and fixed costs are under management's control. Members are making AOL a daily part of their lives, while critical mass has been reached in Europe. Finally, as Steve Case stated, the new organizational structure is benefiting the company greatly.
Usage. Membership climbed by over 1,150,000 subscribers in the past quarter, to 11.8 million total. This was, surprisingly, the third fastest-growing quarter membership-wise. AOL was able to add near-record subscribers with marketing expenses of only 12.1% of revenue, down from 20.6% of revenue a year ago. In the current fourth quarter, though, AOL is increasing marketing to compensate for the typical seasonal slowdown (most Foolish people like to sign off and go outside during the summer, thankfully).
During the quarter AOL reached a record 675,000 simultaneous users during peak hours. This has climbed to 690,000 since. Web hits climbed from 260 million to over 800 million in the quarter. Finally, an unfathomable 200 million instant messages (IMs) were sent daily over AOL networks over the past quarter. (Probably a good percentage of these happened within the Motley Fool's global headquarters. How might you spell "annoying?" How about: "IM.")
The average member spent 46 minutes online per day, up 5 minutes from last year, while average daily usage has more than tripled since the December 1996 flat rate was initiated.
Ad and Commerce Revenue. Advertising and commerce revenue grew to $117.9 million, up from $68.6 million in last year's same quarter. Backlog contracts in this department (committed revenue, but not yet recognized in the P&L numbers) climbed to $427 million, up $107 million from December. Merchandise sales were scaled back as inventory is shifted from AOL's merchandise market to commerce partners, resulting in higher margins for both AOL and those commerce partners, so this move makes sense for everyone.
Infrastructure. AOL's Digital City is now the number one local guide for communities and cities, and 2.9 million people use it every month. In the local content network, Digital City New York is now on both AOL and the Web. Digital City New York sets the stage for the launch of Digital City 2.0 across the country in the coming year. On the Web, AOL.com -- AOL's homepage -- is seeing increased page views and 30% of the page's users now come from outside of AOL. Finally, AOL Enterprises recently announced a deal with Lotus and Oracle.
CompuServe: This service is economically viable again, especially as it is now utilizing AOL's infrastructure and cutting costs. Teleserve, already on AOL, has signed a multi-year deal on CompuServe. AOL will soon launch a new marketing campaign for CompuServe in order to make the public aware of the brand again -- it's the leading professional online brand. AOL plans to hold the membership level at or near 2 million until marketing testing is complete. Then AOL will launch a new CompuServe ad campaign in 1999 to grow membership.
AOL International. The joint venture with Bertelsmann AG now has over 2 million combined members, including over 100,000 members in Japan (most others are in Europe). A Hong Kong service should be available within the next year, and down under, Australia will be given a service this summer.
COO's Summary. The key to the success in all these areas is the new corporate organization. Efficiencies through all operations are being achieved or improved, while AOL is leveraging its leading online brand. The company has laid a strong foundation for future success and hopes to be very capable at continually improving performance in designing, creating, and promoting interactive brands and products.
Lennert Leader (CFO) speaks. The company has reached a point where it should be able to experience sustainable profitable growth and increased flexibility. In the past quarter AOL beat key financial targets, doing so especially with pretax income at 9.1% of revenue, 30% above the street consensus estimate. This was partially due to sharply reduced marketing expenses and better than expected advertising revenues.
Membership. As Bob Pittman touched on, as of March 31, AOL had 11.87 million members worldwide. On April 16 the company topped 12 million. CompuServe has 2.1 million. AOL is conservative in all of these numbers in that it doesn't include bad debt subscribers -- those likely to drop off. AOL saw strong membership growth and strong retention rates. Pricing adjustments didn't increase membership churn.
Ad Commerce. Again, advertising and commerce revenue was up 72%, and these revenues have seen an average 42% quarter-to-quarter improvement in the last three quarters. AOL is also taking a conservative approach in booking ad and commerce revenue. And backlog of this business is growing, but we shouldn't expect to see such aggressive growth in the next quarter.
As Steve Case mentioned, AOL is shifting more to advertising and commerce revenue and away from merchandising revenue. This gives AOL better margins and less inventory risk. Finally, "Other revenues" was down $5 million due to CompuServe's revenues not being enough to replace loss of ANS.
Margins and Costs. Gross margins are down from 37% two quarters ago to 33% in December, and now back up to 34% gross margins this quarter -- better than expected. Higher advertising revenue and lower costs of running the network helped gross margins. While "other costs and expenses" represent an equally good story as does revenue and earnings -- stronger than expected results.
Product development costs were 3.9% of revenue primarily due to CompuServe, while general & administrative costs were flat as a percentage of revenue.
Operating Cash Flow. Operating cash flow is building tremendous momentum, having grown from $12 million less than two years ago to $214 million in the past quarter. Cash from operations should continue to grow, but the growth will be somewhat lower than the March quarter due to some one-time gains. AOL's cash balance grew to $924 million from $518 million. Of that, holdings of publicly traded companies represent about $320 million in value (with $240 million in unrecognized gains). Approximately $100 million is from CompuServe.
CFO's Summary. AOL's multiple brand, multiple revenue strategy is working well. In the fourth quarter, marketing spending will increase substantially to promote the launch of AOL 4.0 and grow customer acquisitions even during the slower summer season. The company has added flexibility with its initiatives due to the membership price increase, a strong balance sheet, and cost controls. AOL will reinvest in improving the customer experience and building brand support and new business.
The company reported better than expected income for this quarter, but investors and analysts shouldn't increase earnings per share estimates for the June quarter because AOL plans to increase marketing expenses and investments in the business, and network costs are unpredictable.
Question and Answer Session
Q: Gross margins going forward with the WorldCom deal now kicking in -- where should gross margins stabilize? Also, can you discuss non-subscriber revenue backlog?
A: Gross margins are helped by the 5-year agreement with Worldcom (that allows for lower prices) and with the subscriber price per month increase fully taking effect this quarter. So gross margins should improve going forward, though AOL can't give estimates. Growing revenue backlog of course gives increased visibility.
Q: Can you give details on the relaunch of AOL.com?
A: That will happen this summer. AOL will beef up functionality and features and prepare to compete more with other content aggregators on the Web. There will be a more significant presence on the Web with the 4.0 product -- personalization, customization, etc.
Q: Marketing costs were down quite a bit... but what were you spending the money on? I didn't see a lot of TV commercials. Also, if there is a delay on Windows 98, what impact could there be on AOL? And also, any thoughts on the highly publicized $150 AOL stock price news?
A: Windows 98 shouldn't have the same type of impact as Windows 95, plus AOL is bundled with nearly every PC sold, so Windows 98 shouldn't have much impact on AOL one way or another. Marketing: AOL experienced higher membership numbers with less spending, but money was spent on direct marketing, partner marketing, and television almost all through the quarter. Finally, the $150 stock price number was not a prediction, it was merely a hypothetical valuation based on numbers that are in the market... based on projections for next year's membership levels and the corresponding market value.
Q: Are there any changes in advertisers' commitment to the medium? Any trends or new big names stepping up?
A: Companies that were not considering Internet advertising in the past are now considering it. A large portion of this advertising is coming directly from companies, not agencies, so the ads are very results oriented, much like cable was in the 80s. Later agencies might pick up the ad buying. A fair number of advertisers are seeing the Internet as a way to do some market share shifting. Get in early, take new market share. Plus, advertising commerce on the Internet is not limited just to the traditional ad budget at a company, but to catalog budgets, brochures, direct marketing budgets, and more. So, big players could be based on marketing and sales budgets, not just ad budgets.
The mood has shifted from "Should I advertise on the Web?" to "When should I?"
Q: Can you give the status on AOL Wallet and Photo album initiatives? And please share worldwide membership numbers.
A: Both projects have significant upside as they both have mass market appeal. The wallet aims for much more convenient Internet commerce, and the photo album is a killer consumer application. AOL should be announcing partners for these projects in the not too distant future.
As for members, AOL had 10, 715,000 in the U.S., and 1,070,00 in Europe... and 100,000 in Japan. Total of 11,875,000 at the end of last quarter.
Q: Strategy for NetChannel? Marketing and architecture?
A: Television does need to be interactive, but the market might not be there yet. There is a long-term opportunity and a partnership for AOL is important here as the company will do evaluations of platforms and features.
Q: Where is your increased usage coming from? What is it replacing? And how can you reach the consumer that doesn't see your marketing efforts in this medium, if you target it?
A: Most online usage replaces the television. AOL takes consumers from there and so it advertises there. But then AOL also tells about its product with brochures, telemarketing, catalogs, magazines, etc... It must explain the product and why people need it in print usually, rather than on 30 second TV spots. And then there are actual transactions online -- 800 number fulfillment, retail space, catalogs again. AOL is taking a piece of that.
Closing Summary: The company is very pleased with its growth across the board. Subscriber growth was strong, its costs are contained, the cash position is substantially higher, and there are numerous initiatives to improve the experience for members, while expanding AOL's role in several new areas. AOL is very pleased by the past three months of progress and is looking forward to a bright few years. Overall, AOL is experiencing sustainable quarter-to-quarter profit growth while investing for future growth.
(America Online is a holding in the Motley Fool's real money Fool Portfolio. Fool on!)
* 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.
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