It is a typical jam-packed Saturday at a Wal-Mart in Hanover County. Struggling against the crowd, a man steers his heavily laden cart toward the parking lot. Pushing back, his two young sons try to direct the cart toward the vending machines lining a wall. "No gum," says the man forcefully. "But," he says, noticing a bright blue bin piled high with free America Online disks, "you can have a couple of those CDs." The boys happily scoop up handfuls and follow their dad to the car, scattering disks along their path.

Carpet bombing nontechies with free offers in stores is just one ploy that has made AOL the highest-valued company in Virginia and one of the most powerful in the U.S. With such shrewd marketing, AOL's youthful executives - chairman Steve Case and president Bob Pittman - created the world's largest online community, garnering status reserved for rock stars rather than corporate suits. Smitten investors pumped up AOL stock so high that the Dulles-based business could buy out Old Media giant Time Warner, a company with four times its sales and vastly higher cash flow. Along the way, AOL emerged as the New Economy champion of the Old Dominion, changing the state's reputation from a government- contract backwater to a high-tech juggernaut on a par with Boston or the Research Triangle.

Click forward to the spring of 2002 and the screen looks very different. AOL is simply one cog in a much bigger wheel at the new corporate headquarters in New York. AOL's chieftains don't rule Time Warner, but vice versa. In Virginia, AOL has laid off several hundred workers because of the merger. AOL's net operations housed near Dulles International Airport have lost some of their dot-com allure. Situated near an abandoned farmhouse, silo and vacant discount store along Route 28, the cluster of buildings looks a lot like any other un-hip suburban office complex.

Likewise, AOL cuts a much lower profile in Richmond these days. Gone is the era when Case schmoozed with Richmond lawmakers and former Gov. Jim Gilmore while AOL staff orchestrated the development of pioneering technology legislation on issues from canning spam to commercial contracts conducted over the Internet.

What's happened? Name it. The dot-com bust, the recession, quantum changes in the Internet market and dramatic new challenges in Internet communications. For AOL, the relatively simple days of selling a one-size-fits-all Internet service accessible on phone lines are over. Looming is the Net's next level: Using much faster broadband links to build the first one-stop-shop for content, from movies to telephone to music to Internet access.

Technically and businesswise, this is uncharted territory. Questions keep mounting. How, for instance, can AOL shepherd a huge, profitable dial-up clientele onto high-speed broadband connections like cable? How does it adapt its best content to work on cell phones and television? How can it exploit its brilliantly timed buyout of Time Warner by putting the latter's books, CDs and magazines online without giving away the store to those who would copy them for resale or give them away for free?

As investors wonder when - and whether - AOL will find satisfactory answers, they are hammering the AOL Time Warner stock. By mid-March it was roughly a third of its 1999 high of $92, or roughly two-thirds of the Time Warner acquisition price.

There's no immediate relief in sight as AOL faces a menu of problems. Spending for online ads, for instance, is comatose. After years of double-digit growth, AOL advertising and e-commerce revenues are down. And the number of new subscribers actually fell, year-over-year, in 2001's fourth quarter, something that has never come close to happening before. Like many a hot-shot tech firm has found, AOL has discovered that cyberspace is not immune to the business cycle after all. This very Old Economy reality has shredded AOL Time Warner post-merger promises of rising cash flow.

Even so, new opportunities abound. According to Frost & Sullivan, a Mountain View, Calif., marketing research firm, multi-media messaging - the text-and-video successor to today's instant messaging - will grow from a $1 billion business today to $26 billion in 2006. Analysts can only guess at how lucrative the market will be if couch potatoes can have instant access to every movie and song ever made.

With this in mind, AOL's new CEO Barry Schuler titillates Wall Street with scenarios of future cash flows that leverage the $24-a-month access fee with a plethora of new services. Among his goals: $15 a month from games, and $20 each from voice, mobile services, music and broadband access. Multiply his total revenue estimates of $159 a month per household by the 25 million domiciles with the wherewithal to lead wired lives, and you get a new annual domestic broadband market of nearly $50 million.

If AOL can snag even part of this burgeoning opportunity, it will remain at the center of the New Media universe, with all the good that entails for Northern Virginia's employment, venture capital and real estate values. The long-term prognosis is pretty good, says Rob Martin, an analyst with Arlington-based investment bank Friedman Billings Ramsey who sees AOL Time Warner as "better positioned than any other company" to exploit tomorrow's telecom market.

The problem - especially for Wall Street - is that the payoff is down the road, while the problems are here and now. AOL is sputtering as it tries to gear up for the bright future. It faces fresh competition from contenders it had crushed before. One is Microsoft, whose MSN Internet access service actually snagged more new customers than did AOL in 2001's fourth quarter. "We doubled our subscriber base in the past year," crows Lisa Gurry, MSN Product Manager. She goes on to list a series of software upgrades, promotions and content partnerships slated for the coming year, all designed to keep the momentum going.

This is vintage Microsoft: Introduce a so-so product, and methodically upgrade until it's pretty good. Then price it aggressively (broadband MSN is $40 a month, versus $55 for AOL) and squeeze. "They are making MSN the front end for Windows XP, which is essentially a broadband operating system," says Martin, the Friedman Billings Ramsey analyst. Combine Windows desktop dominance with a fast-growing MSN, toss in Microsoft Passport consumer wallet software, which saves a user's preferences and tracks online purchases, and you've got a potent offering. "They're equally matched," says Martin, something that AOL can't be happy to hear.

Almost as scary as a fully engaged Microsoft is the migration from dial-up to broadband. By 2005, an estimated 50 percent of U.S. homes will connect to the Internet through fat-pipe connections such as DSL and cable modems, according to Soundview Technologies in Greenwich, Conn. Broadband subscribers will be enthusiastic buyers of high-margin stuff such as movies-on-demand, fast music downloads, personal videoconferencing and Webcasts of major events. So moving its current customers onto high speed connections - and charging them for all these new services - is key to AOL's continued growth.
Yet it is not clear how AOL gets there from here. Time Warner Cable gives it broadband access to about 20 percent of U.S. homes. And AOL is making the most of the relationship, says Audrey Weil, former head of AOL's broadband efforts. "We rolled out [broadband Internet services] to 20 cities in 2001 and ... by June we'll be all the way through Times Warner's [39-city] footprint."

But cable access to most homes is still controlled by rival operators such as AT&T Comcast and Cox, which so far have shown little interest in cutting deals favorable to AOL. "AOL continues to talk about pending deals with [cable system operators]," says FBR's Martin, "but they've yet to sign one beyond Time Warner cable." The fear, says Martin, is that AOL will lose the key to its perceived success on narrowband, which is the ability to offer ownership of access in tandem with the service.

Ownership is indeed the sticking point, says Cynthia Brumfield, president of Bethesda, Md.-based consultancy Broadband Intelligence. "The cable operators attitude is 'You give us $20 a month and we'll call it a day'. AOL is saying, 'So, let's share revenues,' and cable operators don't like that," she says. In lieu of more cable dance partners, AOL has fallen back on a Bring Your Own Access (BYOA) strategy of quietly letting cable modem customers keep their $23.90 AOL account, and offering a $15 service only to those who call in to cancel. So far, so good. Of AOL's 4 million broadband customers, Martin estimates that 67 percent retain their dial-up AOL subscription. In his earnings model, he now assumes no cable deals, but projects that AOL will get 40 percent of new broadband customers via BYOA.

Maybe, but adding $24 for AOL to $45 for a cable modem creates a disturbingly wide price gap between AOL and other Internet service providers at a time when the quality gap is shrinking. Over the long run, such a high price premium doesn't seem sustainable.
The solution? Content, of course. To offset its cost disadvantage, AOL will have to create broadband's must-have products, and fast. Give it tomorrow's must-have content - movies, the most popular instant messaging service and most downloaded music - and cable operators will have a powerful reason to invite AOL in on favorable terms, reasons Brumfield. Since content is AOL's forte, and Time Warner is a treasure trove of music and video, this would, at first glance, seem eminently doable.

Here we hit the second speed bump on AOL's journey to broadband land. Content companies haven't figured out how to offer songs and movies in an interactive format. "The record companies have been very shortsighted on how they deal with online music," says Brumfield. They went to court to shut down Napster, the file-sharing service that introduced millions to the joys of downloading music. But they haven't replaced it with anything workable. "Everybody I know does unlimited downloads from Kazaa.com [a Dutch site], which is beyond the reach of the record companies," she says.

Illustrating the record labels' profound cluelessness, in early February the Recording Industry Association of America announced that despite the demise of Napster, CD shipments fell 10 percent in 2001. The culprit? Not the Internet, but CD burners, which are now standard equipment on mid-range PCs. Rather than paying $16 a pop for new CDs, people, especially teen-agers, are simply borrowing their friends' CDs and burning copies.

As for movies, don't expect to download "Shrek" or "The Matrix" anytime soon. Video-on-demand will happen, but initially through cable set-top boxes, says Brumfield. "This is a logical upgrade from pay-per-view. It's eminently technically doable." The Internet version, she says, is several years down the road.

While all of the above is going on, the final trend - convergence - is gathering steam, as the differences between PCs, cable boxes and cell phones blur, with the next generation of each able to access high-speed Internet, instant messaging and music. AOL founder and current AOL Time Warner Chairman Steve Case, after shunning the spotlight for most of the past year, reemerged recently as the company big-picture guy, laying out his vision of convergence in a series of speeches and interviews.

"I've had only two big ideas in my life," he told a group of money managers at a Media conference in December. The first was that an easy-to-use online service would be popular; the second is convergence. He then went on to list the slew of new convergence initiatives that AOL will roll out by year-end, including HBO-on-demand, instant messaging via cell phones, an alliance with Sony to create home networking products and a subscription music site.

The job of implementing Case's vision of a wired world falls to AOL CEO Schuler, 48, a techie from birth who built his own computers before they were mass-market items. Schuler founded a software shop called Medior in the early 1990s, and had the foresight to take on the job of redesigning the graphical user interface for a fledgling online service called AOL. After AOL bought him out in 1995, he boarded the mother ship, and was reportedly instrumental in giving it the look the world has come to know and, in many cases, love. As president of AOL Interactive Services Group, he then oversaw the "AOL Anywhere" strategy of making rudimentary AOL features accessible from cell phones, pagers and TV. Schuler is, in short, the logical choice for the job of making convergence happen on AOL's terms.

In the near term, though, the man on the hot seat is Kevin Conroy, former head of worldwide marketing for BMG, the record unit of media giant Bertelsmann, who now heads AOL Music division. It is his job to meld the company's Winamp audio jukebox, Spinner Internet radio and AOL Music Channel into a force capable of realizing the ideal of making any song ever recorded available 24/7 from any information appliance. Soon he will oversee the launch of what AOL hopes will quickly become the leading online music service, offering an extensive library of downloadable songs for a monthly fee of around $10.

It's a tantalizing vision, but once again the near-term reality is more sobering. The centerpiece of an AOL music juggernaut is the ability to let subscribers download music. According to San Francisco-based AOL spokeswoman Ann Burkart, AOL's subscription music service will offer 100 monthly downloads from a library of 78,000 songs, mostly from Warner Music Group, BMG and EMI. "We expect the catalogue will continue to grow," says Burkart. Yet a beta version of the service, created to work out the kinks and give early adopters a taste of things to come, has been released and withdrawn. And "we don't have a set launch date," Burkart says.

The news is a little better on the wireless side, where AOL instant messaging "is potentially a huge application for young people," says T. Michael Walkley, a wireless communications analyst with Canadian investment bank RBC Capital Markets. And wireless carriers, it seems, are more open to doing deals than are their cable cousins. In January, AOL and AT&T Wireless began offering AOL Instant Messaging to the latter's huge customer base.

But here again, the recession has slowed the march toward global wireless broadband. In 2001, cell phone sales actually fell, perhaps the first time that's ever happened. And in the excitement of the late 1990s, wireless carriers bid tens of billions of dollars for next-generation spectrum, saddling themselves with debts that are slowing their buildout of networks capable of handling things such as multimedia messaging.

AOL has faced stumbling blocks before, such as during the early 1990s when few took its vision seriously or in the mid-1990s when a shortage of computer servers led to infuriating waits to gain access to AOL over phone lines. Each time, the firm regrouped and moved on.
Now, however, the problems are more complex. There are huge uncertainties as the Internet prepares to move to its next level after the dot-com bubble popped and bloated telecommunications overbuilding sapped financing. AOL is struggling to find its footing as it waits for pilot programs to bear visible fruit. If AOL is true to its history, it probably will emerge triumphant again.

Return to Virginia Business - April 2002