Fool Portfolio Report
Monday, May 12, 1997
by Mike Buckley (MBuckley)
and Brent Harris(BH Apollo)


ALEXANDRIA, VA., (May 12, 1997) -- The Fool Portfolio fell 0.56% today, as America Online and Iomega fell softly on no news. The S&P and Nasdaq rose sharply, up 1.56% and 0.68%, respectively, on the hope that the Fed won't raise interest rates in its Tuesday meeting next week.

Today we present a column of debate focused on one of the most talked-about and controversial stocks on the market. Having compounded 86% annual growth over the past five years, this stock has outperformed 95% of all others -- and yet it is and has been one of the most heavily-shorted issues on the market.

The hot topic of debate: America Online.

As we sit on the brink of a "new age," cliche as that sounds, it is true, and America Online may still present a great opportunity for lucid investors with foresight; or, the stock may be overpriced, and the Internet and online world over-estimated in earning power.

Brent Harris and Mike Buckley are Dueling Fools. Brent has been an active member in Fooldom for the past two years, and has written on subjects ranging from the basics of investing to the intricacies of the financial services industry. His contestant, Mike Buckley, is an avid investor and well-known Fool who loves discussing both the good and bad aspects of the story behind a stock.

Mike tells us he is fortunate to have reaped great profits from a past investment in AOL, but now he's more bearish on the stock than bullish. Why? Once he forms an opinion about the qualitative aspects of a company, ultimately it's his impression of the numbers that determines whether or not he likes the current prospects of an investment.

As these two long-time Fools ponder the fate of AMERICA ONLINE (NYSE: AOL), the undisputed online services leader, they can't seem to agree on which way the stock is headed. Fistfight? Hardly. Brent and Mike have been Fools long enough to know the merits of civil debate, even when they can't come to terms over the merits of a particular equity. So grab a seat! It's time for "Brent the Bull" and "Mike the Bear" to argue the pros and cons of one of the most talked of stocks in Fooldom. May the best Fool win!

Brent with the bullish argument for AOL...

It's a new world, and AOL is leading. The networked world is best described as an unrivaled museum, capable of being accessed from any place at any time by anyone. Inside this museum is housed a treasure trove of all forms of media. There are the complete works of Shakespeare, the entire archives of SEC filings, vast collections of art (although some might not call all of it art), and even a website run by a bunch of Fools. It is a simple truth, dear Fool, that the networking revolution is changing the world. Whether it's shifting the balance of power in the financial world out of the hands of the privileged into the hands of the individual investor, or allowing men in Minnesota to post their manifestos for thousands to read, a difference is being made.

At this network based virtual-museum, there are thousands of entrances providing access to its contents. These entrances are run by companies with names like "Worldnet" and "Mindspring." But, one entrance, with its own entire wing of the museum, stands out from the rest. It is a blue painted building with three large white letters written across it that say "AOL."

AOL is more popular than ice cream. Some say that at night over a million people have been known to crowd at the door to get inside AOL's museum. In fact, the doors become so clogged that the wait to get inside rises to several hours. All these people are clamoring to get access to a bodiless mass summed up in one word: content. AOL's customers know that not everything inside will be to their liking, but next to the alternatives, the chat rooms are just a bit cozier, the choices a bit less overwhelming, and the content is usually of a slightly higher quality.

With this kind of racket the Peter Lynch in all of us would expect AOL to be raking in a fortune. Upon examining AOL's financial statements, one notices that their revenues have climbed steadily, but profits have had more ups and downs than a Stephen King novel, despite the great demand. The demand is so great that AOL must spend a small fortune merely attempting to provide access to their current customers. When AOL switched to flat rate pricing, the resulting demand was so great that people couldn't get on the service for weeks and sued the company as a result.

Advertising revenue is in infancy at AOL. Money made at the company in charging for access is currently substantial, but the big bucks to come are in advertising coupled with revenues from partnerships and similar deals involving online commerce. Currently, in doing the arithmetic, something does not add up in the advertising category. AOL derives mere millions from advertising out of a pie where advertisers spend hundreds of billions yearly on television and print ads. With millions of subscribers, the potential market is enormous. AOL is just beginning to earn revenues here.

With a current market-cap of only 4.75 billion dollars, the potential this company has seems to be discounted heavily. Sure, Mike, there is plenty of turbulence in store for this company, which I'm sure we will hear more about when it's your turn to talk, but even you cannot deny that AOL possesses the foremost franchise in networking. Coupled with a savvy management team, whether or not Bill Gates sneezes, Greenspan raises interest rates, or they have another unprofitable year, AOL is going to be successful ten years from now.

And now Mike with the bearish perspective...

Brent, thanks for taking the time to go one-on-one with me in this enjoyable debate. Though I'm not in favor of owning AOL stock right now, I believe the company is a superbly managed brand that is dominating its industry. My concerns have to do with the bottom line over the long term, the nature of doing business in the unproved online world, the valuation of the stock, and AOL's changing business model.

A long-term look at the bottom line. In recent years the earnings have looked like a roller coaster. FY94 profits were $6 million, FY95 losses were nearly $34 million, and FY96 profits were nearly $30 million. Now that the accounting method has been changed to be more revealing the losses in the most recent four quarters add up to $490 million. Ouch! Regardless of how many one-time charges we continue to recognize as investments in the future, there will be a time when investors expect steady profitability, an element which in recent years has been elusive.

Operating in the online world. No one appreciates the world of cyberspace more than me, but life in the fast lanes of bandwidth isn't nearly so euphoric as the spin doctors would have us believe. It's ironic that IBM's advertisements on the Internet focus on businesses not making money at their websites. Neither of us believes that families want to surf the Web (or AOL) in the living room the way we watch television. Trying to offer something to everyone, AOL's content became yet another massive, unmanageable mini-Web within AOL.

Further, once the customer stumbles onto AOL content worth repeatedly visiting, quality of service continues to be inconsistent; it's generally better than access on the Internet, but when it's not it's far worse. Consider the three C's: content, convenience, and community. Consistently achieving any two of them over a long period of time has proved to be a daunting task. This is true whether there have been two million, five million, or the current eight million subscribers. Tell me, Brent. Just how many subscribers does it take to screw in the proverbial AOL light bulb?

The value of the stock. As I write this, First Call shows 5-year average annual growth at an estimated 50%. With the stock already trading at roughly 55 times next fiscal year's earnings estimate, it is not undervalued. The Fool's Jeff Fischer used sound logic in February when he arrived at a current fair value of $53.50 using a subscriber-based valuation. That doesn't leave much room for growth from the current price of $50 -- and certainly not enough room to justify the risk. Granted, Jeff stated that he didn't attempt to account for advertising or transaction revenues, which are admittedly growing, but difficult to predict.

Even so, I would be hesitant to add much more to the implied $53.50 fair value knowing that the stock's current price tag is already more than 100 times book value (Yikes!) and the price-to-sales ratio is over 3.5. That's for a company that had a decline in gross margins in the last quarterly report, and is struggling to generate positive operating cash flow and profits.

AOL's changing business model. The company's revenue base is changing from the days gone by of the usage-by-the-hour model within the United States to a mix of flat-rate subscriptions, dramatically increased advertising revenue, fees from Private AOLs (PAOLs) that are corporate networks using AOL's interface, and revenue from partnerships in the various international AOLs. I believe implementation of the change has potential for being the single biggest weakness in the current AOL story.

Sweeping changes in business models sometimes work and sometimes don't. Though the changing model is necessary in my opinion and is probably being implemented by the best management team in the business, the risk to investors has already proven to be a story replete with negative surprises. Until the transition to the new model is substantially completed and proved successful, I'm a Virginian living between the Fool's and AOL's headquarters thinking as if I live in Missouri. Show me. Specifically, show me consistent net earnings and positive operating cash flow.

For me, Brent, the risks I've touched on are not reflected in the stock's current price. I am grateful that our friendship would never have come to be were it not for AOL. That's just one of many reasons why I'm happy to be America Online's customer, though for the moment not one of its investors.

Brent strikes back...

Mike, you argue that a major risk to AOL is that the networked world is not yet profitable for companies and attractive to the majority of Americans. I do not disagree that surfing the web or meandering through an online service is not yet a living room activity. However, the potential that is already possessed in networking through access to information and games, coupled with its communication options, has proven to be a very valuable tool in itself.

Selling in the online world. As for companies doing business in cyberspace, it is the unfortunate truth that many will not succeed. This is inevitable for any medium. However, there are also many companies that will succeed, and in some cases are already succeeding greatly. At this time, DELL COMPUTER (Nasdaq: DELL) is selling over a million dollars a day worth of computers at its website. Even more impressive is CISCO SYSTEMS (Nasdaq: CSCO), a company that is currently selling its networking products over the Web at a rate of one billion dollars a year -- incidentally, they expect that rate to soon double.

Cyberspace efficiency. Sure, many companies are still running seemingly huge losses by utilizing networking technology. However, many studies show that these losses are more than made up for in efficiency gains. Take Cisco Systems as an example of this point as well. A recent New York Times article stated that Cisco saves $535 million a year as a result of the benefits from online efficiency. Those savings add up to 8% of Cisco's revenues, a gain in efficiency and profitability well worth the cost.

As for America Online being overvalued, I am afraid that valuations based upon estimates only one year out is a very short-term view for a company that is just capitalizing on what appears to be a potential gold mine: advertising. AOL has millions of subscribers whose eyes are worth hundreds of millions of dollars to advertisers. All in all, America Online has a lot of potential that if unlocked over time, may greatly reward long-term investors in its stock.

Mike lashes back...

I've gotta hand it to you, Brent! As I mentioned to you privately, I really enjoyed your very creative, cunning contribution to our fun debate. Knowing you had darned few specifics to support your case, I greatly respect your adroit presentation of glowing generalizations that are so exciting and compelling on the surface that even I was almost lulled into forgetting the importance of digging deeply into the details.

Details about AOL, Fool! More details! :)

AOL's network quality. You're right in your earlier statement that "AOL spends a small fortune merely attempting to provide access to their current customers." Currently adding about 25,000 modems every month, AOL is forced to spend and spend and spend just trying to keep up with the subscribers. It's too bad that a study conducted by Inverse Network Technology in February confirms the need.

Of the ten biggest national providers, AOL's network had by far the worst reliability. Considering the reputation for poor service widely reported in the media (along with everything I mentioned in my earlier piece), no wonder the market tends to value AOL's subscribers as little as one-fourth that of cable television subscribers and as little as one-half that of the cellular telephone subscribers.

Advertising dollars are going WHERE? You're also right about the comparatively minuscule advertising revenues AOL is getting. In 1996 all of the online publishers such as AOL captured only $40 million in advertising dollars. Yet $260 million in ad dollars, or six-and-a-half times more, went to the popular Web sites, such as Yahoo! and Netscape. (Numbers courtesy of Jeff Fischer, Fool writer.) You'd think that AOL would have attracted a disproportionately large share of advertising revenue considering its role as the undisputed leader in both categories of online and Internet service providers.

Not so. AOL lags competing cyberspace sites in obtaining ad dollars. Taking into account Internet usage provided by Nielsen Media Research, those numbers tell us that AOL got somewhat less than their fair share of the market. Not good for a company whose changing business model banks on dramatically increasing advertising revenue.

You think the current market capitalization heavily discounts the potential of AOL. I think that a scant six months ago, when the market cap was nearly half of what it is today, the stock price more properly assessed the total picture -- including the risks and details.

EPILOGUE

Don't race for the exits yet! That battle, in the eyes of this editor, was a draw. You may have some thoughts on your own, no matter which side of the AOL fence you fall on; or you may want to hear more. If so, head over to the America Online message board where Mike, Brent and countless others are ready to keep the civilized debate alive.

Other Links:

AOL in the Fool Port -- the past two years of information.
AOL Company Snapshot.

---by Mike Buckley and Brent Harris, May 12, 1997

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TODAY'S NUMBERS
Stock Change Bid -------------------- AOL - 7/8 49.88 T + 1/8 32.88 ATCT - 3/8 3.94 CHV +1 3/8 72.75 DJT + 1/8 10.00 GM + 7/8 58.75 IOM - 7/16 18.38 KLAC - 1/2 48.25 LU - 3/8 62.88 MMM + 7/8 92.38 COMS - 3/8 38.00
Day Month Year History FOOL -0.56% 4.61% 0.26% 167.58% S&P: +1.56% 4.53% 13.08% 82.74% NASDAQ: +0.68% 6.62% 4.12% 86.65% Rec'd # Security In At Now Change 5/17/95 980 Iomega Cor 2.52 18.38 629.17% 8/5/94 355 AmOnline 7.27 49.88 586.04% 8/11/95 125 Chevron 50.28 72.75 44.68% 8/12/96 110 Minn M&M 65.68 92.38 40.65% 10/1/96 42 LucentTech 47.62 62.88 32.05% 8/12/96 280 Gen'l Moto 51.97 58.75 13.04% 8/24/95 130 KLA Tencor 44.71 48.25 7.91% 8/12/96 130 AT&T 39.58 32.88 -16.94% 4/30/97 -1170 *Trump* 8.47 10.00 -18.08% 8/13/96 250 3Com Corp. 46.86 38.00 -18.91% 10/22/96 600 ATC Comm. 22.94 3.94 -82.83%
Rec'd # Security In At Value Change 8/5/94 355 AmOnline 2581.87 17705.63 $15123.76 5/17/95 980 Iomega Cor 2594.53 18007.50 $15412.97 8/12/96 110 Minn M&M 7224.44 10161.25 $2936.81 8/11/95 125 Chevron 6285.61 9093.75 $2808.14 8/12/96 280 Gen'l Moto 14552.49 16450.00 $1897.51 10/1/96 42 LucentTech 1999.88 2640.75 $640.87 8/24/95 130 KLA Tencor 5812.49 6272.50 $460.01 8/12/96 130 AT&T 5145.11 4273.75 -$871.36 4/30/97 -1170*Trump* -9908.50 -11700.00 -$1791.50 8/13/96 250 3Com Corp. 11714.99 9500.00 -$2214.99 10/22/96 600 ATC Comm. 13761.50 2362.50-$11399.00 CASH $49020.02 TOTAL $133787.65