AOL gets last laugh on free Net access

In the brief history of the Internet, the death of America Online has been predicted countless times.

After the Web's mainstream explosion in the mid-1990s, pundits said consumers would outgrow the closed, training-wheel environment of an online service like AOL and graduate to direct dial-up connections that catapulted them to the wilds of cyberspace, using portals like Yahoo for navigation.

While Web portals chased traffic in a strategy based primarily on advertising for revenue, AOL plodded along with far smaller numbers, but its customers provided steady monthly income through paid subscriptions. So when the ad market froze last year, AOL became the proverbial tortoise that beat out the hare.

"What Yahoo is going through is no different than what AOL went through four or five years ago when we had to change our business model, when Wall Street was putting pressure on us," said Barry Schuler, now the chief executive of AOL Time Warner's America Online unit. "And we figured it out; we made it work."

Today, Web rivals that banked on free services are desperately trying to figure out if they can change course and follow AOL's strategies without undermining their original businesses.

Most of the portals long ago abandoned the idea of getting into the Internet access business because it was so expensive to maintain and would severely limit the potential to attract as much traffic as possible for ad dollars. Internet service providers that sold dial-up Web access without portal features were never able to catch up to AOL's membership, which it grew largely through an unparalleled marketing juggernaut, even after the largest ISPs merged and began to make money.

"AOL was saying when no one else was onboard that it was important to marry access with a content service. They were hurt by that because they didn't have a 'pure-play' Internet company," said Andrea Williams Rice, an equity analyst with Deutsche Banc Alex Brown. "In the end it doesn't matter. They were right."

AOL Time Warner becomes powerhouse
Perhaps most perplexing, Web companies know that others have tried to beat AOL at its own game--including vaunted Microsoft, with its own subscriber service--with little success. The few portals that have tried to follow AOL's model of tying Internet access to content programming, such as Excite@Home and Terra Lycos, have stumbled badly in those attempts.

At last count, AOL had 29 million subscribers who purchased $20 billion worth of goods and services through the online service last year, according to the company. That formidable membership will now be exposed to all manner of promotions from Time Warner's global empire of magazines, cable service and entertainment studios.

To be fair, few outside the company predicted that it would become the powerhouse it is today as AOL Time Warner. In fact, the access business nearly destroyed AOL in 1997, when the company experienced massive service blackouts after changing its pricing plan from hourly charges to a flat rate--a move that drew so much traffic that it overloaded the networks.

The outages led to lawsuits by dozens of states representing angry members who complained about the poor service, giving other companies even more reason to avoid the ISP business. AOL was seen as having "this dirty, nasty access business with low margins," Rice said.

Yet those margins, which widened just days ago with a surprise rate increase, are precisely what allowed AOL to weather the economic tumult that now threatens competitors that pursued a free strategy.

As taxing as it was at the time, the outage fiasco was a blessing in disguise, company executives now say. It forced them to turn to other types of revenue to offset the increased network costs, and AOL became a media company that made money through advertising and e-commerce, as well as dial-up connections. Last quarter, advertising and commerce revenue for the AOL unit hit $721 million.

"We didn't know exactly how the flat-rate model would work out, but we did feel we had to have other revenue streams as well," Schuler said. "It ended up causing us access problems and caused us to scramble to expand capacity. We all took a blood oath that that would never happen again."

Others took vows of their own to stay out of the network business altogether.

The competition's conundrum
For AOL's competitors, the way to success appeared obvious at the time. Web portals such as Yahoo attract millions of people every month and earn their dollars through advertising and e-commerce. But the portal market imploded, leaving AOL, Yahoo and Microsoft's MSN to share the bulk of advertising dollars.

Of all the leading online companies, Microsoft has probably experimented the most with the portal and ISP strategies. It has fervently tried to take out AOL since 1995, when it launched MSN as a proprietary online service. That effort failed to attract enough consumers, and the company soon split its access and Web content businesses.

Microsoft has since refashioned MSN into a portal and branded its other Web properties under the MSN moniker. The company shifted again last year, launching MSN Explorer, a software product that links many of the company's Web efforts into one service: MSN.com, its Internet Explorer browser, MSN Hotmail and its Windows Media Player. Consumers using MSN Explorer can also get Internet access.

Microsoft is opening an attack on the pricing front as well, trying to lure AOL subscribers irked by the service's recent rate increase. But MSN, which is believed to be hemorrhaging red ink, plans to increase revenues in other ways, such as charging fees for multiplayer games, music services, video on demand and Internet phone calls.

"It's hard to raise the price from free to a paid price. That is a difficult transition to make," said Bob Visse, MSN group product manager. "We want to add additional services beyond what people expect they can get for free."

Yet all of this may be too little and too late to topple AOL, which has littered the portal landscape with its conquests.

When @Home acquired Excite.com in 1999, the company envisioned a service that would combine high-speed access over cable with a popular Web portal as its start page. Consumers, however, did not flood Excite@Home with requests for cable modem service.

Terra Lycos has had difficulties pursuing this route as well, through services with standard household speeds. The company earlier this month slashed its 2001 revenue forecast to $624 million to $650 million after initially expecting $900 million.

Of the portals, Yahoo remains the one to watch as the ultimate bellwether for the free-Web industry. Some believe it's not too late for the company to fight AOL on its own turf, with Internet access.

"If anyone wants to compete with AOL--and I'm looking at it more from the access standpoint--then they're going to have to buy EarthLink," Frank Gristina, an analyst at Robinson-Humphreys, said of the leading consumer ISP. Yahoo is "clearly trying to generate premium services, and access is the ultimate premium service for the Internet."

Experimenting in portal land
None of this is to say that AOL has always been immune to the lure of the free Web. Only a few years ago, Yahoo, Lycos, Excite.com and Infoseek put tremendous pressure on AOL to compete against them for traffic at a time when Wall Street was rewarding those numbers with skyrocketing stock prices.

In 1998, AOL told Wall Street it would use the recently acquired ICQ instant messaging service as one element in the company's multi-brand portal strategy, along with AOL.com and its CompuServe subsidiary. AOL then acquired Netscape Communications later that year, adding that company's Netcenter portal to the list.

"Much like the strategy of Yahoo and its ilk, AOL used those types of free services as a way to lure people into its Web sites," said Mark Mooradian, an analyst at Jupiter Media Metrix.

For the most part, however, those portal initiatives appear to have been largely defensive moves to prevent coveted members from leaving the online service for the competition.

AOL.com, which has largely remained an offshoot of the subscription service, has since been renamed "AOL Anywhere." Instead of highlighting Web searches and other portal functions, the site's primary mission is to offer AOL members a way to use their e-mail or chat services on the Web.

AOL "didn't create a huge portal brand, but I don't think that's what they set out to do," said Abhishek Gami, an equity analyst at William Blair. "They referred to any non-AOL brand as a 'flanker' brand. They fight on the periphery of the battle and very selectively pick off elements of the enemy."

In the end, much of AOL's success can be attributed to values that are distinctly Old Economy, lessons learned from established media such as newspapers, magazines and cable television.

No one knows this more than Bob Pittman, the co-chief operating officer of AOL Time Warner and former MTV executive whom many believe is the heir-apparent to lead the media conglomerate.

As he put it in a recent speech: "The good news is once you have a subscriber, it's hard to lose him."