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Wednesday, June 23, 1999

An Investment Opinion
by Louis Corrigan

AOL and Hughes: A Serious Warning Shot

The partnership announced Monday between America Online (NYSE: AOL) and satellite company Hughes Electronics (NYSE: GMH), provider of DirecTV, has been interpreted partly as a warning to cable system operators. The extent of this warning, though, has been underestimated.

Cable companies have been reluctant to negotiate a deal that would allow AOL to offer its customers high-speed Internet access via cable given the cable systems' control of broadband access companies -- and AOL competitors Excite@Home (Nasdaq: ATHM) and Road Runner. Yet, AOL had already struck deals with Bell Atlantic (NYSE: BEL) and SBC Communications (NYSE: SBC) to offer customers high-speed digital subscriber line (DSL) Internet access via telephone lines. Add in the pact with Hughes, and it's obvious that AOL has other high-speed access options, options it will pursue, perhaps along with broader partnerships. As AOL Chair/CEO Steve Case told the Wall Street Journal, "Maybe this creates a little more incentive on [the cable operators'] part to work with us sooner rather than later."

Both sides in this struggle have been keen to protect and enhance their negotiating position. As fellow Fool Bill Barker and I discuss in today's Dueling Fools, that battle has been fought in the courts and, increasingly, in the court of public opinion, where controlling how the debate is framed rhetorically may prove important to controlling the outcome. Yet, I continue to believe that investors have misconstrued the fundamental power dynamics at work here.

Much has been made of broadband cable's threat to America Online. And perhaps rightly so. The cable system operators, led by new cable king AT&T (NYSE: T), would like to fundamentally alter the value chain in this important market. Today, dial-in access is largely a commodity sold and resold for cheap. The real value resides with companies like AOL that deliver a great consumer experience, including content, community, and service. These companies resell inexpensive access while reaping fat profits from their customer base thanks to high-margin advertising and e-commerce revenues. With its top brand and 16 million plus customers, AOL today rules this value chain. But cable system operators want to leverage their control of high-speed pipes into an online consumer franchise that would usurp AOL's crown.

The thinking is simple. We all want faster access to the Internet than standard 56k dial-in modems can deliver. The cable operators have been first out of the gate in offering high-speed Internet access, mainly via @Home. The Bells have been slower to roll out their DSL service. And high-speed satellite and wireless connections haven't had much impact and probably won't for a few years. So to get high-speed access, you now pretty much have to go to @Home, which becomes your $50 a month Internet service provider (ISP). Want AOL, too? Fine, but it's going to cost you more. Some customers may opt to pay the extra monthly charge; others may embrace the Excite@Home ISP experience and forget about AOL.

This sounds pretty good for @Home. Sure, the recent court decision in Portland threatens to throw a roadblock in the path of @Home by forcing cable operators to lease AOL and other ISPs the same access to their broadband pipes that they've leased to @Home. But let's assume AT&T wins this case on appeal or the Federal Communications Commission changes the rules and says cable systems can do what they want. Even then, would cable operators and thus @Home really be in the drivers seat?

In my view, no. The reason is simple. America Online is in a position to form partnerships with providers of digital broadcast satellite services (DBS), satellite and wireless Internet access providers, local telcos, and various long-distance providers, such as MCI Worldcom (Nasdaq: WCOM), which already provides AOL's dial-up access. Through such partnerships, AOL potentially could destroy the U.S. cable industry -- or at least leave it reeling.

The fact is, cable operators want to do it all, offering over a hundred crisp digital television channels, movies on demand, local and long-distance telephone services, high-speed two-way data transmission, and e-commerce. Cable's potential for selling loads of new services to existing cable customers while attracting new customers or winning back recent defectors has pumped up valuations in this consolidating industry.

The calculus holds that the current revenue stream (X) is secure while new streams can pump overall revenues up significantly in the future (maybe 2X or more). But with AT&T and cable operators going after business now held by competitors in various fields, there's really no guarantee that cable won't induce the kind of cooperation among its competitors that could leave the average cable operator looking at declining revenues (maybe 0.5X). As much as they stand to gain in the new world of converging technologies, cable operators also have a lot to lose. But nobody seems to be doing the math on that part of the equation.

The Hughes deal calls for AOL to invest $1.5 billion for convertible preferred stock paying 6.25% per year. After three years, the preferred converts to Hughes common at a rate determined by the market price of Hughes at the time. What does AOL get for this investment? A lot, including a total of $205 million in direct Hughes' advertising and commerce spending over the next three years. The pact also will allow AOL to reach the estimated 30% of the U.S. populace that still won't be able to get any broadband access via cable or DSL by 2003.

Altogether, Hughes will spend over $500 million to market AOL-Plus (AOL's broadband service). It will also purchase $150 million worth of marketing over AOL as part of a $500 million marketing effort to boost DirectTV subscriptions, which now total 7.3 million. It will also spend another $400 million to subsidize the cost of rolling out AOL TV-enabled set-top boxes to DirecTV's subscribers. Hughes will shell out another $100 million to market DirectDue, which lets one satellite dish provide access to both DirecTV and DirecPC, its Internet access service that allows downloads at 400 kilobits per second. Finally, the deal will support Hughes' $1.4 billion investment to design and launch its new two-way high-speed connectivity solution, dubbed Spaceway, due to become available in 2002.

Sure, only 40,000 people get broadband access today via DirecPC's somewhat clunky system whereas about 750,000 customers use broadband cable access. And @Home alone expects to top a million customers by year end. AOL's alliance with Hughes, though, marks just one of many that it has formed and no doubt will form in the future. The stakes are high not just for AOL but for AT&T and other cable operators that think they have a chance to control the value chain in the multimedia connectivity market. As I see it, the cable operators are playing a game of chicken they cannot win. They know that, and that's why they will eventually swerve from their current course and negotiate an access deal with AOL.

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