ter for interactive communications with full-ļ¬‚edged message boards and live chat. The
Web, on the other hand, was mainly a publication environment for reading. The question
remained, what would be the role of online service providers in the future? Would they
become just another Internet access provider with their own look and browsers or could
they continue to offer something unique to users?
Some analysts were projecting that the U.S. online services market would grow 30ā“
35 percent annually through the year 2000, and that the Internet market would grow even
faster. These analysts expected America Online to retain about a 20 percent market
share.5 On the other hand, Forrester Research of Cambridge, Mass., predicted that the
big three, America Online, CompuServe, and Prodigy, would continue to add subscrib-
ers only through 1997. After that, Forrester predicted, it would be all downhill for the
AOLā™S RECENT PERFORMANCE
For the fourth quarter ended June 30, 1995, America Online announced that its earnings
were $0.16, excluding $0.01 merger expenses and $0.02 amortization of goodwill. This
was a signiļ¬cant improvement over 1994ā™s fourth-quarter earnings, $0.02, and above an-
alystsā™ estimate, $0.14. Service revenues surged to $139 million, versus analystsā™ esti-
mate of $132 million, and total revenues rose to $152 million versus $40.4 in the fourth
quarter of 1994. For the ļ¬scal year ended June 30, 1995, AOL reported a loss of $33.6
million on revenues of $394 million compared with a proļ¬t of $2.5 million on revenues
of $116 million a year earlier. New charges recorded for the ļ¬rst time in 1995 included
$50.3 million for acquired R&D, $1.7 million amortization of goodwill, and $2.2 mil-
lion in merger expenses. (See Exhibit 3, America Onlineā™s 1995 Abridged Annual
New subscriber momentum continued to be strong, increasing 233 percent year-over-
year and adding 691,000 new net subscribers during the fourth quarter. All major metrics
used by analysts to evaluate AOLā™s franchise and gauge the āhealthā of its rapidly grow-
ing subscriber base also improved during the quarter: projected retention rates rose to 41
months from 39 months; paid usage grew to 2.93 hours from 2.73, and projected lifetime
revenues per subscriber increased to $714 from $667. (See Exhibit 2 for the history of
America Onlineā™s User Metrics.) However, analysts were projecting lower gross mar-
gins in the future as subscribers continued to transition to higher-speed access and as
AOL introduced a heavy-usage pricing plan in response to Microsoftā™s lower per-hour
On November 8, 1995, America Online announced its results for the ļ¬rst quarter of
ļ¬scal 1996 ended September 30, 1995. Even though revenues rose to $197.9 million
from $56 million a year earlier, America Online reported a loss of $10.3 million com-
5. āAmerica Online, Inc. ā” Company Report,ā A. Pooley, The Chicago Corporation, April 18, 1995.
6. Op. cit., Forbes , August 28, 1995.
2-29 Part 2 Business Analysis and Valuation Tools
pared with a proļ¬t of $1.5 million a year earlier. America Online took a $16.9 million
charge to reļ¬‚ect research and development taking place at Ubique, a company it ac-
quired on September 21, 1995, as well as to pay off other recently acquired assets. It took
another charge of $1.7 million for amortization of goodwill. These charges were par-
tially offset by AOLā™s decision to increase the period over which it amortized subscriber
acquisition costs. Effective July 1, 1995, these costs would be amortized over 24 months
rather than 12ā“18 months. The effect of the change in accounting estimates for the three
months ended September 30, 1995, was to decrease the reported loss by $1.95 million.
AOL also announced that it added 711,000 subscribers in the ļ¬rst quarter of 1996, bring-
ing its total subscriber base to four million.7
America Onlineā™s stock price had been on the move since the companyā™s initial public
offering (IPO) in March 1992. The stock price appreciated from the IPO price of $2.90
to $7.31, $14.63, and $28.00 at calendar year end 1992, 1993, and 1994, respectively. At
its current price of $81.63 (dated November 8, 1995), the companyā™s market value was
around $4.0 billion. (See Exhibit 1 for the stock price history of America Online, its eq-
uity beta, and additional market-based data.)
THE CONTROVERSY SURROUNDING AOL
America Onlineā™s stock was one of the most controversial of this period. Some analysts
promoted the stockā™s potential for price appreciation, while others recommended selling
the shares short to proļ¬t from a decline in price. Bulls saw America Online as part of a
revolution in communication, like cellular phones and cable television in the early days.
They considered AOLā™s graphical interface software, its high-speed Web browser, and
Mr. Caseā™s marketing genius (subscribership had quadrupled to over four million in a lit-
tle over a year) to be major competitive advantages. Bears, on the other hand, anticipat-
ing new entrants competing in the online services industry and a migration of
subscribers to the Internet, questioned whether AOL would continue to experience high
growth in its subscriber base or be able to retain existing subscribers.
Shortsellers had sold around seven million America Online shares, betting that the
stockā™s price would not go up forever. Shortsellers pointed to the recent hedging activi-
ties by Apple Computer to lock in proļ¬ts on its 5.7 percent stake as an indication that
AOLā™s stock was overvalued. Adding fuel to the shortsellersā™ ļ¬re, corporate insiders at
AOL had sold some of their shareholdings. Between March 9 and March 15 of 1995,
seventeen insiders sold approximately 200,000 shares, including the company founders,
President Steven Case (25,000 shares for $2.1 million) and Chairman James Kimsey
(40,000 shares for $3.3 million).8
7. āAmerica Online Posts $10.3 Million Loss But Says Revenue Rose 250% in Quarter,ā The Washington Post, Nov. 8, 1995.
8. As of August 15, 1995 all executive ofļ¬cers and directors as a group continued to own 3,729,547 shares, Steven
Case owned 1,036,790 shares and James Kimsey owned 679,616 shares.
62 Strategy Analysis
Adding to the controversy, some analysts labeled AOLā™s accounting āaggressive.ā
AOL amortized its software development costs over ļ¬ve years, a long time in the fast-
changing, uncertain online services industry, and AOL capitalized subscriber acquisition
costs when its number one competitor, CompuServe, did not. Furthermore, effective
July 1, 1995, AOL extended the amortization period for its subscriber acquisition costs
from about 15 months to 24 months. Given the uncertainties surrounding AOLā™s sub-
scriber retention rates and revenue growth as competition emerged in the young industry,
analysts questioned the wisdom of AOLā™s accounting decisions. The big risk AOL faced
was that eventually customers could switch on-line services as frequently as they now
move among long-distance carriers.
While America Online expensed the free trial expenses (i.e., those charges incurred
from the ten free hours given away in the initial month), it capitalized the marketing
costs associated with acquiring a customer including direct mail, advertising, start-up
kits, and bundling costs. As indicated in its annual report, prior to July 1, 1995, the cap-
italization had occurred on two schedules depending on the acquisition method. Costs
for subscribers acquired through direct marketing programs were amortized over a 12-
month period. Costs for subscribers acquired through co-marketing efforts with personal
computer producers and magazine publishers were amortized over an 18-month period,
as these bundling campaigns had historically shown a longer response time. However,
effective July 1, 1995, AOL increased the period over which it amortized subscriber ac-
quisition costs to 24 months for both acquisition methods.
Defending AOLā™s accounting choices, Lennert Leader, the Chief Financial Ofļ¬cer of
America Online, Inc., said that the company was following standard accounting proce-
dures in matching the timing of expenses with the period over which the revenues would
be received. He argued that the companyā™s marketing and software development ex-
penses produced customer accounts that last a long time. Thus, he said, it was appropri-
ate to write off the costs over a period of years, even though AOL had spent the cash.9
However, some analysts raised red ļ¬‚ags about AOLā™s accounting choices. As noted
in the October 24, 1995 Newsweek article:
One of AOLā™s hidden assets is the brilliant accounting decision it made to treat its
marketing and research and development costs as capital items rather than ex-
penses. . . .
AOL charges R&D expenses over a five-year period, a very long time in the on-
line biz. In July, AOL began charging off marketing expenses over two years, up
from about 15 months.
Why change to 24 months from 15? Leader said itā™s because the average life of
an AOL account has climbed to 41 months from 25 months in 1992. How many
AOL customers have been around for 41 months? Almost none, as Leader con-
cedes. Thatā™s understandable, considering that AOL has added virtually all its
9. Op. cit., Newsweek, October 24, 1995.
2-31 Part 2 Business Analysis and Valuation Tools
customers in the past 36 months. Leader says the 41-month average live number
comes from projections. Of course, it will take years to find out if heā™s right. . . .10
Analysts were also concerned about AOLā™s cash ļ¬‚ow situation and the signal sent by
the timing of its latest equity offering. The Newsweek article continued:
Accounting is terribly important to AOL. The better the numbers look, the more
Wall Street loves it and the easier AOL can sell new shares to raise cash to pay its
bills. . . . On October 10 [AOL] raised about $100 million by selling new shares.
AOL sold the stock even though its shares had fallen to $58.37 from about $72 in
September, when the sale plans were announced. Most companies would have de-
layed the offering, waiting for the price to snap back. AOL didnā™t, prompting cyn-
ics to think the company really needed the money. . . .
Some analysts believed that AOL issued shares when its stock price was low because
the company needed the cash immediately. Others argued that AOL was building a war
chest needed because deep-pocketed rivals such as Microsoft were about to start an on-
line price war and because increasingly information providers were going directly to the
Internet, rather than using middlemen such as AOL. Some analysts interpreted Com-
puServeā™s recent adoption of more aggressive accounting techniques as a sign that it too
was readying for war. Beginning the ļ¬rst quarter of ļ¬scal 1996, CompuServe would cap-
italize direct response advertising costs associated with customer acquisition activity.11
While AOLā™s stock price rebounded to $81.63 by November 8, 1995, there were many
questions concerning AOLā™s future. How would the demand for AOLā™s services be af-
fected by the entry of Microsoft Network and the growth of Internet? Would AOLā™s ac-
counting choices stand the test of time? What if AOLā™s subscription growth rates slowed
or subscriber renewal rates fell? Did AOL have the ļ¬nancial ļ¬‚exibility to face these com-
petitive pressures and accounting risks?
10. Op. cit., Newsweek, October 24, 1995.
11. Op. cit., Newsweek, October 24, 1995.
Stock Price History for America Online, Inc.
AOL Stock Price (indexed)
Mar-92 Jun-92 Sep-92 Dec-92 Mar-93 Jun-93 Sep-93 Dec-93 Mar-94 Jun-94 Sep-94 Dec-94 Mar-95 Jun-95 Sep-95
Additional market-based data:
America Onlineā™s equity beta 1.4
Moodyā™s AAA corporate debt in November 1995 (%) 7.02
Treasury bills rate in November 1995 (%) 5.35
Government 30-year treasury rates in November 1995 (%) 6.26
Sources: Datastream International, Standard and Poorā™s Compustat, and the Wall Street Journal.