Fool Portfolio Report
Thursday, May 9, 1996

by Tom Gardner (TomGardner)

ALEXANDRIA, VA, May 9, 1996 -- The Fool Portfolio gave back a little more today, falling 2.09% whilst the S&P 500 inched up 0.10%. Two days ago---as you well know---America Online closed bidding $70 a share. Today, AMER settled in at $57 3/8. Our once largest holding has fallen 18% in two sessions. And with 111 million shares outstanding, America Online has seen the value of its company decline by $1.4 billion. In two days.


Today's report will concentrate on an analysis of AOL's third quarter announcement, but I want to take care of some other business, first. Let's start with the softer-side of retailing. Sears posted 10.9% same-store-sales growth for the four-week period ending May 4th, and 14% total growth over the period. Fools cheered. "We had broad-based sales gains across the entire store, despite an earlier Easter," said CEO Arthur C. Martinez. Sears traded as high as $53 1/4, before *losing* $1/8 to close at $50 5/8.

The Gap also announced rapid growth, posting $370 million for the four-week period ended May 4, 1996, an increase of 26% over sales of $293 million for the comparable period ended May 6, 1995. Fools again cheered. Gap shares traded as high as $31 3/8, before cruising in at $30 1/2, up $1/2 on the day.

A reminder to all faithful portfolio-report readers, and a heads-up for newbies: Let the Fab-Four Dow Stocks tell you where the market is headed. Back when Sears was esconced in the high-yielding, beaten-down, ready-to-turnaround group, it was time to go fishing for retail stocks. Dividend investors remember that back in 1994, IBM was actually in the select group---and it was time to send the line out into the technology hole. Now, Fool, which four industries are represented:

GM: Automobile
Chevron: Oil & Gas
3M: Chemical and diversified industrial products
GE: Electrical Equipment

That's looking like a fairly defensive group overall. Consider tying your flies and casting lines. Over the past two sessions, General Electric has risen $1 5/8 and Chevron is up $2 1/8. As one new Fool in the office said: They're kicking in for us!

And now let's head off to the land of The Earnings Report and America Online. In the spirit of Moses Malone "Fo', fo', fo'. . ." and the political sweepstakes "Four more years. . ." or "Four new years," I've broken the second half of today's review out into four categories: Strengths, Weaknesses, Unknowns and Valuation.


A. $312 million sales and 14.5 cents earnings.

America Online swept past all Street estimates on the top and bottom lines. AOL's $16 million in earnings---excluding Johnson-Grace acquisition charges of $850,000---exceeded expectations and marks a quarterly record.

B. Entry into Japan.

AOL's made good on their promise to enter the lucrative Asian markets, post haste. AOL will offer localized content, Internet access, and a similar per-month pricing package for subscribers. The service is to be operational by the end of 1996.

C. 6 million global members.

AOL announced that by the end of this week, they'll be servicing over 6 million members worldwide. Subscribers grew by 905,000 in the March quarter up from 870,000 new subs in the December period.

D. The leading online brand

America Online has established itself as the consumer-online brand to beat---globally. In a digital world too fascinated with "cool new apps," AOL has positioned itself with the consumer and committed itself to improving the quality of the experience.


A. The churn.

An aggressive focus on bringing onboard new members has its consequences. Churn rates for the third quarter were simply too high. In the conference call with analysts, AOL emphasized the need to focus on connectivity and customer service issues. To this The Fool would add: content & community presentation. During a three-month period of rapid growth, where AOL should have fallen back on and aggressively promoted its strongest brands, it instead attempted to establish new ones. The blend of overcapacity and the overpromotion of sites that did not attract new or old users hurt AOL this quarter.

B. The new partnership.

As exciting as the new deal is with Mitsui, AOL's entry into Japan will come with notably less capital upfront from its partner. When America Online announced entry into Germany last March, Bertelsmann invested $100 million in cash and $50 million for a 5% equity stake in AOL. Conversely, Mitsui will pony up only $50 million in cash and $28 million in stock, making for just long of 1/2 the committment.

C. The seasonality.

We knew it was coming: the summer slowdown. But it still hurts to hear that America Online will shift its focus from subscriber acquisition to customer satisfaction in the final quarter of fiscal 1996. Just as another Fool holding, Iomega Corporation, is experiencing stronger cashflows and preparing to establish itself as the standard by INCREASING its marketing campaign, AOL is pulling back the reins. We'll have to wait for 3.0 this Fall.

D. Struggling Marketing Plan

This last one is a pet peeve of mine---a matter of preference only. I am not one who was energized by America Online's branding campaign over the past half-year. TV spots at 2 AM with a guy in his den talking about stock quotes didn't catch my imagination. "I can even send e-mail on the Internet." And the monkey glove dropping down on the mouse didn't inspire me. But I'm of the opinion that the immediate future of this medium is tied very closely to education rather than coolness or hipness. AOL had an opportunity to focus on the many wonderful things that are happening in areas like The Better Health and Medical Network (keyword: HRS), the online *experiences* that are having meaningful and favorable effects on many lives. But they aimed to be trendy.


A. The 20/20 pricing plan.

For me this is not as unknown or worrysome of an issue as many have concluded it is. The $20-for-20-hours strategy gives members the time to explore the service, will result in a lower churn rate, and has been tested over the past year. This looks to be both a defensive (competitive) and offensive (customer service) play and I don't expect it will meaningfully effect usage revenues.

B. Who is the competition?

One thing is for certain, competition is going to come less and less from outside. Expect to see far fewer hard-nosedly critical comments in the media by competitors---from Microsoft to AT&T to the other proprietary services and AOL's existing partners. The initial battle for brand recognition and acceptance has been won hands down by AOL. Now the fight for profitability begins. How AOL chooses to play its hand now, as it pauses to strengthen its services this summer en route to the run for ten million, will influence cashflows for years to come.

C. Cashflows

As you well know, this is not an excessively profitable company. AOL has made significant investments in content, connectivity, applications, and subscriber acquisitions and questions remain about AOL's ability to trickle their rapid subscriber and sales growth down to the bottom line. AOL is running 4.5% profit margins. . . its potentially most ferocious competitor (competitive alliance), Microsoft, is still running the bottom-line at over 25 cents on the dollar.

D. 1,000 Partnerships

America Online has not articulated a clear vision to its information providers. Will AOL be a content company that competes directly with its third-party providers? Or will it focus exclusively on creating applications that capacitate its outside providers? And how many online sites will there be on America Online? With upwards of 1,000 today, does AOL risk becoming just a more expensive Web? Quality, quantity and intent issues are at the fore today.


There's absolutely no question in my mind that America Online (NASDAQ:AMER) has NOT traded lower over the past two days because of its 3rd quarter numbers. They were outstanding. Strong sales, earnings and EPS figures again illustrated just how commanding a lead the Company has over its competitors. Prodigy is as good as shuttering itself and CompuServe is---not surprisingly---trading at its low, 13% off its IPO price. The numbers tell a great story.

But the storyteller isn't finished yet. AOL's direction to analysts in the call was to hold their numbers where they stand. . .at essentially $1-$1.2 billion in sales and between 46-50 cents in earnings for the year. Their projections for 10 million in subscribers at some point over the next 12-18 months is more conservative than some at the Company were projecting in quarters past. At some point, a slowdown in subscriber growth is going to demand that AMER investors begin running earnings models (the PEG.) We're not there yet.

With 6.3 million global subscribers targeted for the end of June, with a running tally of $1,000 per sub, you have a projected capitalization of $6.3 billion. At $58 a share and with 111 million shares outstanding, AOL is presentely capped at $6.4 billion. It looks like the Street is playing the cap-game and reserving judgement on future cashflows. It looks to me like the analysts are on top of this one, as they advise a volatile period without much appreciation as we head into the new 3.0 client and new marketing plans in the Fall.

That's generally what my Foolish eyes see. And that's one of the reasons I refer Fools back to those four Dow stocks---GM, GE, 3M, and Chevron. Whether you agree, disagree or neither, please flame me in the America Online folder!

Tom Gardner, May 9, 1996

Today's Numbers

Day Month Year History

FOOL -2.09% 2.35% 71.94% 221.05%

S&P 500 +0.10% -1.34% 4.79% 40.80%

NASDAQ +0.39% -0.23% 12.89% 64.93%

*Scroll down or expand screen for full portfolio accounting

AMER -5 1/2 ...CHV + 1/2 ...GE +1...GPS + 1/2 ... IOMG ---...KLAC + 1/4 ...MDRX ---...S - 1/8 ...

Rec'd # Security In At Now Change

5/17/95 1005 Iomega Cor 5.04 63.25 1155.47%

8/5/94 680 AmOnline 7.27 57.38 688.89%

4/20/95 310 The Gap 16.28 30.50 87.40%

8/5/94 165 Sears 28.93 50.63 75.02%

8/11/95 95 GenElec 57.91 77.00 32.95%

8/11/95 110 Chevron 49.00 57.25 16.84%

1/29/96 250 Medicis Ph 27.86 24.75 -11.16%

8/24/95 130 KLA Instrm 44.71 30.00 -32.90%

Rec'd # Security Cost Value Change

5/17/95 1005 Iomega Cor 5063.13 63566.25 $58503.12

8/5/94 680 AmOnline 4945.56 39015.00 $34069.44

4/20/95 310 The Gap 5045.25 9455.00 $4409.75

8/11/95 95 GenElec 5501.87 7315.00 $1813.13

8/11/95 110 Chevron 5389.99 6297.50 $907.51

1/29/96 250 Medicis Ph 6964.99 6187.50 -$777.49

8/24/95 130 KLA Instrm 5812.49 3900.00 -$1912.49

8/5/94 165 Sears 4772.65 8353.13 $3580.48

CASH $16434.53

TOTAL $160523.91