AOL, The Reluctant King

By Jim Wagner

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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 broadband."

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

But today'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 service.

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 lucrative.

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 today'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 broadband.

"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.'"