Fool Portfolio Report
Tuesday, February 10, 1998
by Jeff Fischer (JeffF@fool.com)

ALEXANDRIA, VA (Feb. 10, 1998) -- With seventy minutes to write before the deadline, and not having looked at AOL's earnings yet, let's see how much a Fool can accomplish in such short order, shall we? We might be surprised.

First, we'll of course have full coverage of America Online's (NYSE: AOL) earnings over the coming days, because you can't accomplish very much quality research in quick time (afterall, we're still in the process of looking at the month-old earnings of Intel in another portfolio). Tomorrow, though, we will have a full summary of the second quarter conference call, which Louis Corrigan (TMF Seymor) has been listening to while I've been doing all sorts of other fun stuff.

First, a Fool can read the earnings report anywhere on the Web, so reposting all of the numbers here, while demonstrating the ability to read and write, is pointless. The deepest that we'll go into the basic numbers is this: Sales rose 45% to $592 million (though only up $70 million from quarter one, or 13%), and net income climbed to $20.8 million, or $0.17 per share, one penny above estimates. The $20.8 million in earnings gave the company 3.3% profit margins for the quarter.

Member retention and growth remained strong, the cost structure continued to improve on many levels, and advertising and commerce revenue grew 87% from last year to $108.8 million. The growth in commerce (and ad) revenue, while not incredibly impressive, came despite the fact that AOL hasn't yet marketed itself very well as an online commerce business to members. Despite this, the company has been signing several large deals with vendors. (AOL didn't share how much money in online commerce passed through its vendors, but it'd be interesting to see and to compare it to sales at companies like Amazon.com.)

Overall, one of the advantages that America Online has is of course the hypergrowth of the Internet, and the company, having emerged as the dominant online service, realizes that it can reduce advertising and still continue to grow at a record pace. Last quarter marketing expenses were reduced to $96.8 million, or 16.4% of revenue, compared to 37.1% of revenue (or $151 million) one year ago. At the same time, the company added 1.2 million new members, crossing above the 11 million member mark on January 20.

The majority of revenue came from online services, weighing in at $483 million. Just yesterday America Online demonstrated that -- wow -- it can raise prices, and though it'll take time to see how membership retention (and growth) changes after the $2 per month price increase, if membership remains steady and continues to climb, then AOL has demonstrated pricing power -- something that not many companies except, usually, industry leaders possess.

I think it's safe to say, though, that confirmed pricing power at AOL will be the outcome of the recent price increase. Members need to consider the switching costs of leaving AOL, not only in relation to price, but also with regard to the inconvenience of changing to a different Internet Service Provider (ISP). That inconvenience will prove, in most cases, too great to merit the switch, while not offering enough price advantage. Once a member has an email account and has shared it with family and friends, has favorite places bookmarked, knows the communities on AOL that he or she frequents, most would rather pay the extra $2 per month than move to a different service.

Let's look again at the earnings statement. Though net cash provided by operating activities was $75 million, the company of course didn't create any free cash flow. Free cash flow is what Intel, Microsoft, and Cisco create in abundance every quarter. It's the cash that is created at the company when you take after-tax earnings and then deduct all capital expenditures that were plowed into the business during the quarter (and free cash flow then accounts for depreciation and amortization in the company's favor, adding it back to after-tax earnings).

AOL is still too young to expect it to create free cash flow, but eventually, let's hope it does. It'd be one of few content/media/online related companies to do so. With $20.8 million in after-tax earnings, depreciation and amortization of $31.3 million added to that, and then property, equipment, and product development costs of $101.5 million subtracted -- nope, no free cash flow created. About $50 million shy this quarter. For the past year, though, it serves to remind that AOL has poured $700 million into its network build-out. Network improvements will be a consistent expense at the company, but the cost should certainly decline.

The company increased cash and equivalents to $518 million from $130 million last year, but $350 million of that is the result of the issuance of low-interest debt.

Finally, what will probably excite most investors for some reason (by the way, the C-K Port wrote well about stock splits yesterday), AOL announced a 2-for-1 stock split effective March 16. Most impressive in the press release was the statement: "A stockholder who bought 1,000 shares for $11,500 at the company's initial public offering on March 19, 1992 and held the stock would, after March 16, 1998, own 16,000 shares valued at approximately $880,000 based on today's prices."

Now that, dear Fools, is explanation enough for employing a buy and hold strategy in leading companies.

All in all, the business is moving along well, serious competition is nowhere in sight, and AOL has yet to fully capitalize on advertising and commerce opportunities, while the implied pricing power in the subscriber model is favorable long term, of course. At current prices the stock trades at a market cap of over $11 billion, while the company now has past 12-month sales of just over $2 billion, meaning the stock trades at 5.5 times sales. Not so bad for a new, fast-growing and profitable market leader, especially if, as costs continue to come under control and other revenue streams ramp up, AOL can push margins much higher. With the market lead that it has, the possibility is very present. It's primarily up to management.

Finally, no news that I saw to account for the rise in Amazon.com (Nasdaq: AMZN), but we'll take it just the same. Tomorrow we'll have America Online's conference call summary. For much more right now, please visit the AOL message board.

Have a great night...

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TODAY'S NUMBERS

Stock Change Bid ---------------- AMZN +5 1/4 63.50 AOL -1 1/2 109.00 T -1 62.19 CHV - 15/16 75.50 DJT - 7/16 11.31 GM + 3/16 63.13 INVX + 1/2 23.75 IOM - 5/16 9.69 KLAC + 11/16 41.19 LU + 7/16 93.81 MMM -1 1/8 86.00 RTN.A + 9/16 53.25 COMS + 3/16 32.56 TDFX --- 25.13 SPY + 31/32 102.25
Day Month Year History FOOL +0.61% 5.83% -0.31% 234.55% S&P: +0.82% 3.95% 5.01% 122.30% NASDAQ: +1.10% 5.54% 8.83% 137.31% Rec'd # Security In At Now Change 8/5/94 355 AmOnline 7.27 109.00 1398.72% 5/17/95 1960 Iomega Cor 1.28 9.69 656.59% 10/1/96 42 LucentTech 47.62 93.81 97.02% 9/9/97 290 Amazon.com 38.22 63.50 66.14% 8/12/96 130 AT&T 39.58 62.19 57.13% 8/11/95 125 Chevron 50.28 75.50 50.14% 8/12/96 110 Minn M&M 65.68 86.00 30.94% 8/12/96 280 Gen'l Moto 48.74 63.13 29.51% 1/8/98 115 S&P Depos. 95.91 102.25 6.61% 12/19/97 17 Raytheon 53.21 53.25 0.08% 1/8/98 425 3Dfx 25.67 25.13 -2.11% 8/24/95 130 KLA-Tencor 44.71 41.19 -7.88% 6/26/97 325 Innovex 27.71 23.75 -14.29% 8/13/96 250 3Com Corp. 46.86 32.56 -30.52% 4/30/97 -1170 *Trump* 8.47 11.31 -33.58% Rec'd # Security In At Value Change 8/5/94 355 AmOnline 2581.87 38695.00 $36113.13 5/17/95 1960 Iomega Cor 2509.60 18987.50 $16477.90 9/9/97 290 Amazon.com 11084.24 18415.00 $7330.76 8/12/96 280 Gen'l Moto 13647.92 17675.00 $4027.08 8/11/95 125 Chevron 6285.61 9437.50 $3151.89 8/12/96 130 AT&T 5145.11 8084.38 $2939.27 8/12/96 110 Minn M&M 7224.44 9460.00 $2235.56 10/1/96 42 LucentTech 1999.88 3940.13 $1940.25 1/8/98 115 S&P Depos. 11029.25 11758.75 $729.50 12/19/97 17 Raytheon 904.57 905.25 $0.68 1/8/98 425 3Dfx 10908.63 10678.13 -$230.50 8/24/95 130 KLA-Tencor 5812.49 5354.38 -$458.12 6/26/97 325 Innovex 9005.62 7718.75 -$1286.87 4/30/97 -1170*Trump* -9908.50 -13235.63 -$3327.13 8/13/96 250 3Com Corp. 11715.99 8140.63 -$3575.37 CASH $11259.61 TOTAL $167274.36