June 13, 1996
HOW DO YOU QUANTIFY ALL OF THIS? I have tried some back of the envelope calculations here ... but in the end they are fraught with peril. There is a lot of uncertainty here. A jagged philosophical division exists between those who see America Online as a computer service and those who view the company as a growing media giant. I am willing to make a few assumptions, though, that you can elect to accept or deny on your own.
1. USAGE IS ELASTIC. Price "elasticity" is an economic concept that suggests lower prices sometimes increase demand and mean more revenues and more profit, even if the price per unit is lower. America Online has spent more than a year building out a network of 160,000 modems and 600 POPs ... easily the largest dial-up network in the United States, if not the world. This built-out has allowed network costs to become much more of a fixed component of the cost structure, meaning lower revenues can still net the same amount of profit. Add to this the fact that America Online has found in their testing of the 20/20 plan that there is improved user retention and enough trading up from the $10 a month price point that net usage revenues actually stay flat.
2. WHO CARES ABOUT NEW SUBSCRIBERS? They are expensive beasts. Think about all of those nasty subscriber acquisition costs. The bears have cornered AOL in a lose-lose situation -- either subs must increase and they whine about the cost of this or subs don't increase as fast and they whine about this. The reality is that AOL could not gain another user and its margins would improve because of the lack of subscriber acquisition costs -- mail-outs, bounty, free hours that use valuable network capacity and so on. The combination of improved margins on usage plus the elasticity means that I think usage will actually grow a little and become much more profitable, making $290 to $300 million in usage revenues higher profit margins is what I am looking for.
3. ADVERTISING MEANS BIG MONEY. Okay, $100 to $200 million is a huge range and maybe $200 million may seem a bit extreme. But even focusing on $75 to $150 million over 12 months means $6.25 to $12.5 million a month, or $18.75 million to $32.5 million more a quarter. This revenue will probably done with accrual accounting, meaning that it will be pushed out over the life of the contract making it end loaded. This is in addition to the $26.9 million or so they did in 'other revenues' last quarter without this, meaning $44 to $58 million in other revenues next quarter is what I would consider a reasonable guess, putting us at $334 to $348 million in revenues.
4. MERCHANDISE AND ENTERPRISE ACCELERATION. $2 million a month on books and CDs means $6 million in the quarter. With 10 or so up in the quarter ending June, the private AOLs look to do $800,000 to $1 million in revenues for the quarter. All told, $6 to $7 million slapped on our other numbers would bring us to $342 to $355 million. This range compares well with last quarters $312.3 million, giving 5% to 10% quarter over quarter growth and roughly 125% year-over-year growth.
5. MARGIN IMPROVEMENT IS THE REAL STORY. Advertising, merchandising and enterprise are all much higher margin that normal service. A slowdown in subscriber acquisition to await the roll-out of the 3.0 clients means higher member service revenues because of lower subscriber acquisition costs. Advertising with 25% profit margins give $4.7 to $8.125 million from advertising. Merchandise and Enterprise at 20% profit margins give $1.2 to $1.4 million. This would suggest that we should do as much as $5 to $8 million more than last quarter, if usage is unchanged. Another way to look at it is to assume this all helps to push overall profit margins up to 6.0% from 4.8% last quarter and $20.5 to $21.3 million in profits, significantly improved from last quarter's $15.1 million. The fact that working the additional revenues by themselves adds more builds a cushion in case usage earnings decrease, an unlikely possibility.
6. SO WHAT WILL THE EPS BE? Got me. AOL is quickly diluting to the 120 million share from 111,000 million shares, meaning next quarter will be somewhere in between there. Assume 116,000 and you have $0.18 EPS compared to $0.14 EPS last quarter and $0.07 EPS a year ago. This is well above the $0.16 EPS consensus but still far below the highest estimate out there, a $0.23 EPS number according to Zacks. This would put America Online at $0.53 EPS for the year heading toward a lot of fat advertising numbers that are end-weighted.
7. NEXT YEAR? Without having built a model, I gotta really just take some guesses. If America Online can do an average of $425 million a quarter next year and continue to improve margins with fat advertising revenues to 8% to 10%, this is $136 to $170 million in 120 million shares, $1.13 EPS to $1.41 EPS next year -- far above the consensus $0.97 EPS that is floating around. The high end here is above the $1.21 EPS high estimate out there but well within range given the entire new revenue stream that will come pouring in.
Randy Befumo (MF Templar), a Fool