AOL, The Reluctant King

Almost every national Internet service provider in the U.S. has had a
comprehensive broadband policy in place for years; that is, except for the
largest one in the world.

America Online, the AOL Time Warner unit with more than 33
million dial-up subscribers in the U.S. and abroad, has been surprisingly
reticent to date about advertising or otherwise promoting broadband to its
dial-up following.

While its primary rivals in the U.S. — MSN , Earthlink
and United Online — were busy
signing deals with any and all incumbent telephone and cable networks and
launching nationwide campaigns, AOL stood seemingly aloof for the most part.

Although AOL Broadband is available throughout the U.S. over a digital
subscriber line (DSL), and it offers a similar service through its Time
Warner Cable (TWC) network, not many AOL customers are aware of the service.

The benefits of broadband access, and the attendant revenue benefits to
offering the service, can’t be ignored. With more than 7.12 million cable
Internet customers and 4.6 million DSL customers in the U.S. (according to
In-Stat/MDR), broadband is quickly going mainstream.

What’s the reason for the relatively unheard-of AOL high-speed services?
The answer is simple: it hurts.

“Overall, they’ve been dragging their feet a little bit developing a
broadband strategy because they’re making money on dial-up right now,” said
Mark Kersey, a broadband analyst at ARS Inc. “It’s a tough position for
them to be in, because every day they’re losing dial-up subscribers to

“The struggle for them is ‘how do we have a broadband strategy while not
essentially depleting our margins?'”

But Wednesday’s restructuring deal with AT&T Broadband and
Comcast Corp. signals a change in AOL’s broadband song;
not only is the ISP looking to correct its broadband strategy, but it’s
going to have a coming out party that it hopes will give it major clout on
the national scene.

To date, AOL’s ownership of TWC has been a relative bust, mainly due to the
company’s insistence on maintaining the AOL brand throughout by charging a
premium for the content — on top of the already-hefty price of broadband

The belief that AOL users would pay almost any amount for AOL content has
been keeping the ISP going for years. In the dial-up world, users have
swallowed the monthly price of Internet access at another ISP, while paying
an additional fee to access AOL content and email address.

But that price becomes a little too steep when it comes to broadband: not
many people are willing to pay at least $50 a month to get DSL or cable
service, then pay an additional $15 every month for AOL content.

According to a report in Newsweek this week, when AOL customers
switch to cable Internet service through TWC, they are given a choice
between AOL’s pricey plan and plain TWC access at a lower price: customers
are dropping AOL entirely and keeping the TWC service.

It all comes back to the service AOL has been providing since its
inception: dial-up with an international community that’s the envy of every
other ISP in the world. The ISP has dial-up service down to an art form
and, what’s more, it owns the infrastructure, making profit margins very

Broadband service cuts into that profit margin, however, and is one of the
reasons AOL has been hesitant to enter the fray. Besides the higher price
per subscriber broadband brings, the ISP doesn’t own the POPs or network
the broadband is offered upon.

So, the onus is on new America Online chief executive officer, Jonathan
Miller, to cut deals that give the ISP a starting point in the broadband
industry, and one that won’t decimate the bottom line.

It can be assumed Miller will reach a deal with TWC after the company goes
public, most likely even before the new cable company becomes a separate
entity from the AOL Time Warner mothership. But Wednesday’s deal with AT&T
Broadband and Comcast gives the ISP even more playing room in the cable
Internet arena.

As part of the deal, Comcast agreed to let AOL resell its services on the
Comcast network. The three-year, non-exclusive deal is likely one of the
main reasons AOL Time Warner signed off on a deal that gives AT&T Broadband
and Comcast $2.1 billion, $1.5 billion in stock and a 21 percent equity
interest in TWC.

The resell agreement between Comcast and AOL certainly isn’t
cheap. According to a Wall Street Journal report, AOL will pay
$35-40 for each subscriber it garners on the Comcast network, plus a
percentage of the advertising and e-commerce revenues garnered from those
Comcast customers. Details on the month access fee are still being ironed
out, according to AOL officials at a press conference today.

That’s a hefty price tag in the cable world, which generally ranges in the
$25-30 per subscriber range.

“Every story you see about AOL, where they have some sort of a deal, they
end up being put in a position where they have to charge a premium for
their broadband service,” said Alan Mosher, Probe Research senior research
director. “What this tells me is they’re going to have to retail it to
consumers somewhere north of $50 just to make a profit.”

Admittedly, that’s cheaper than the price for users who have AOL content on
top of their existing cable Internet bill, but it puts the ISP in
relatively uncharted waters.

“Dial-up they have down pretty well, they’ve been doing it for 15 years,”
Kersey said. “Broadband, they have to utilize someone else’s
infrastructure, and if they’re paying $35 bucks a month, their gross
margins are only in the 20-25 percent range, which means there’s not a lot
of room there. When you factor in marketing, operating costs, etc.,
there’s really not much left.

With Time Warner Entertainment (TWE) properties getting rolled back into
the AOL Time Warner fold, AOL the ISP is forced to cut some deals to have
any shot in the broadband market down the road. After TWE and TWC merge
its operations and go public, AOL will be left without even the token
broadband offering it has with TWC.

Once TWC goes public, AOL becomes just another ISP in the eyes of the new
company, especially to federal regulators at the Federal Communications
Commission (FCC) and Federal Trade Commission (FTC) who will be
scrutinizing any broadband access deals the two make after the initial
public offering (IPO).

Mosher believes AOL has an uphill struggle to gain any clout in the
broadband market going forward. Sweetheart deals between carrier and
content companies — such as those between Yahoo! and
SBC Communications , and the deals between MSN and Verizon Communications and Qwest
Communications — paints an ugly picture for AOL growth in

“AOL is in danger in any of those (broadband) markets they enter,” Mosher
said. “They’re going to have to buy the service at some sort of wholesale
rate and always be in the danger of having their rate undercut by their
vendor, who is also a competitor.

“They obviously, desperately want to get into the game and it seems they’re
willing to give up a lot just to get in the game.”

Ken Marlin of investment banking firm Marlin & Associates, said it’s a
little too soon to count out the largest ISP in the world, with one of the
largest portals and huge name recognition value.

“(This deal) gives AOL tremendous access to the Comcast network,” he
said. “AOL, MSN, Yahoo!; all three have achieved enough critical mass in
the U.S., to the point where they can go up to any ISP and say, ‘hey, let’s
make a deal.'”

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