Merging with Time Warner will allow America Online use its scale to position itself in what amounts to the sweet spot of access commoditization -- which is one of the great demons now driving this industry. From there, AOL/Time Warner can, at its own pace, drive the central pillar of AOL's current business model -- low-margin subscription Internet access -- right into the ground, while building a new model on that spot.
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A recent study on residential Internet access by communications research firm Strategis Group found that over 12 million people have sampled ad-supported services, a number expected to triple by 2005. Industry rule of thumb says only about half of those registering with a free service will use it during a given month, however, so the reported numbers need to be taken with a grain of salt.
Helping to fuel the free access phenomenon is the declining cost of network bandwidth and the growing ability to profile online users, which allows both personalization and the delivery of highly targeted advertising. For users, the service is about getting a free connection to the 'Net. But the business of providing that connection is about advertising and direct marketing, and not Internet access itself.
Despite initial similarities, the companies providing free Internet access and the conventional ISP are hardly in the same business. For ISPs such as EarthLink (Nasdaq: ELNK) and AT&T's (NYSE: T) WorldNet Service, revenues come from subscribers, who pay monthly fees to access the Internet; for free access providers such as NetZero (Nasdaq: NZRO) and CMGI's (Nasdaq: CMGI) 1stup.com, the revenue stream begins with advertisers and other commerce partners, who pay to have their ads shown to the service's users.
Turning the free access model into a self-sufficient business means scaling the active user base as well as the advertiser base so that ad revenue covers the cost of giving away the all-important connection. The question mark hanging over the free access providers -- what some consider their fatal flaw -- is whether they can stay in business long enough for that to happen. The question mark hanging over subscription ISPs is how free access will affect their business. And that question casts an especially long shadow over America Online (NYSE: AOL).
AOL's subscriber growth has remained strong; it claims to get about half of all new Internet users. But as the nation's largest provider of Internet access, AOL has the farthest to fall with the rise of the freebies. The company downplays the impact of free access on its business, saying it has no plans for a free service in the U.S. Besides, they say, the free access business model isn't viable. (AOL operates a free service in the U.K., where telecom regulation creates a vastly different economic landscape.)
But the questions keep popping up: Does AOL need to respond to free ISPs? Does it need to start one of its own?
The free ISP, AOL-style
Whether or not ad-supported ISPs are fatally flawed, the immediate problem with the free model -- that ad revenues don't support the cost of providing service -- are easy enough to see. But while the model might not be viable generally, the situation is different for AOL, and will become even more so if its merger with Time Warner (NYSE: TWX) is completed.
In an SEC filing detailing its reasons for the merger, Time Warner said combining with America Online would accelerate the "digital transformation" and infuse all of its businesses with "a heightened digital focus." They didn't guarantee that. But expectations are clearly high for Time Warner's current businesses once they are "powered by" AOL. And what of America Online's business?
Subscription fees from the AOL service currently constitute about 65% of America Online's total revenues, but will represent less than 15% of revenues for the combined AOL Time Warner, based on each company's most recent quarterly results. This turns AOL's current revenue picture on its head, and shines a new light on the free access business model -- AOL-style.
As a component of AOL Time Warner, the flagship AOL service will be set free from its current role as America Online's bread and butter, and can serve as a broader resource for the new, "digitally transformed" company. This new role would justify the service being subsidized -- invested in -- by the other AOL Time Warner businesses. It also points down the path that leads to a free AOL service.
Under this arrangement, AOL could price itself competitively, although its current ability to charge a premium to the market shows it doesn't need to compete on that basis. However, if AOL merely cut prices to the industry norm, it would pressure subscription fees across the board, which wouldn't make things any easier for the already struggling access providers, free or otherwise.
As today, the value and usefulness of the flagship AOL service increases as its subscriber base grows. But instead of the service's access revenues supporting the smaller ad and commerce operations of today's America Online, we find a giant media operation subsidizing the declining per-user costs of its own distribution system: AOL.
Merging with Time Warner will allow AOL use its scale to position itself in what amounts to the sweet spot of access commoditization -- which is one of the great demons now driving this industry. From there, AOL Time Warner can, at its own pace, drive the central pillar of AOL's current business model -- low-margin subscription Internet access -- right into the ground, while building a new model on that spot.
Your Turn:
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