Can AOL keep pace?
The old dial-up service plays catch-up by going free, but Fortune's Stephanie Mehta argues the plan's unlikely to result in big gains.
By Stephanie N. Mehta, Fortune Magazine senior writer

(Fortune magazine) -- By our count, AOL has announced four let's-fix-this-puppy plans in as many years. And almost all of them, despite great hype, have turned out to be fairly modest proposals.

In December 2002, the unit of Time Warner (Charts) (parent of Fortune's publisher) said it would try to stem defections from its core dial-up business by charging customers a reduced subscription fee to access AOL over other providers' broadband connections, a service known as Bring Your Own Access. A few years later AOL said it was turning itself into a Yahoo (Charts)-like portal in a bid to attract more users and advertisers. Earlier this year the company talked up plans to co-market broadband services with phone and cable companies.


Then, in early August, Time Warner president and COO Jeff Bewkes and AOL chairman and CEO Jonathan Miller announced the latest turn of the screw: The company will give away e-mail accounts, AOL's famed easy-to-use client software, and other services in a bid to retain relationships with AOL users switching to broadband in droves.

While the giveaway means that AOL is sure to lose subscription revenue, management figures that it can drastically cut costs tied to running its dying dial-up business - AOL says it plans to eliminate 5,000 jobs in the next six months - and gain new revenue through online advertising.

Growing revenue, shrinking base

Indeed, AOL's ad revenue grew 40% in the second quarter, well above analysts' expectations, and revenue per 1,000 page-views has increased 80% in two years. But much of the audience AOL amasses for advertisers comes from its declining subscriber base; with free mail, AOL hopes to keep in the fold broadband users who otherwise would have started using, say, Google's (Charts) Gmail or Comcast's (Charts) e-mail service for their electronic missives.

"We're going to stop sending our members to our competitors," Bewkes said on a conference call with analysts. He added dramatically, "I want to stop and let you all dwell on that statement." AOL says that it will launch the free e-mail accounts and other swag in September, and that the move won't affect its projected cash flow for the year.

AOL and Miller get points for continually evaluating and improving the business, yet one can't help but feel that AOL - once an Internet pioneer - remains several steps behind the competition. Google, using its sophisticated search engine, created a new advertising category, and Yahoo became a key component of big advertisers' marketing plans.

Companies that didn't even exist four years ago, such as MySpace, YouTube and Skype, changed the way many millions of consumers spend time or communicate with one another online.

The market has rewarded such boldness: Google, which went public in August 2004, has seen its stock more than quadruple. News Corp (Charts). spent $580 million to buy MySpace's parent company. Time Warner shares, meanwhile, trade for about $17 a share - exactly where they were two years ago.

AOL's effort to create a free web portal is by far the most ambitious of its moves, but even that comes years after Yahoo and Microsoft's (Charts) MSN attracted millions of loyal users with a similar strategy. Jessica Reif Cohen, the Merrill Lynch media analyst, once expressed disbelief that AOL, with all its music know-how - and its relationship with Warner Music, which Time Warner eventually sold - didn't invent something like iTunes, the Apple (Charts) music service. It is likewise disappointing that AOL, with its loyal cadre of teen and preteen users, didn't come up with the equivalent of social-networking site MySpace.

Life after dial-up

AOL had become a laggard even before its disastrous merger with Time Warner. Back in the late 1990s, when the cable companies were just starting to deploy cable modems, AOL management felt confident that consumers would be slow to adopt broadband and therefore didn't start laying the groundwork for life after dial-up.

Then came the merger, and AOL's top executives spent the next several years trying to run the combined company. By that time broadband was a real problem for AOL.

To make matters worse, the company couldn't fulfill the growing demand for online advertising, because it used a proprietary publishing system that made it hard for marketers to plug their ads into AOL's sites.

"I think they looked up in 2003 and realized they were driving a Model T in a NASCAR world," says Jeff Lanctot, vice president of Avenue A/Razorfish, a digital-advertising agency that works with clients such as Best Buy and Weight Watchers. "They were ill-equipped to compete with more nimble competitors."

By all accounts, AOL has fixed its ad problems, and CEO Miller insists that AOL is not playing catch-up and is "contemporary" with its peers. "But we need to be leading," he adds.

So how to win back former AOL customers and woo Google and Yahoo users? Alas, some of the ideas Miller offered are compelling but not mind-blowing: In the coming weeks, he says, the company will offer services that surpass what competitors now give away: AOL users will get five gigabytes of free storage - twice what gmail users get; free antivirus protection for their computers (some providers just protect e-mail accounts); and vanity domain names for e-mail users (he, for example, could be, if it isn't taken already).

Still, these kinds of tidbits are unlikely to result in big market-share gains for AOL. "Until Google gives them a reason to leave- or until AOL takes a huge leap forward - it will be a slow grind to win them back," Lanctot says. "And AOL is grinding, taking little wins along the way."

One bright spot for AOL lies with a business the company has said relatively little about: video on the web. The same week that AOL provided Wall Street with its big strategy update, the company quietly announced plans to revamp its video portal, offering thousands of hours of video programming, including full-length TV shows. Some of it will be ad-supported and free to view; other programs will be downloadable for a fee.

AOL rivals Yahoo, Google, and MSN all are trying to build video businesses - as are companies such as NBC Universal, which recently cut a deal to run clips and promos on YouTube. No company owns the video-on-the-web space - yet - but AOL might just have a slight edge. "Not to drag you into that old debate about synergy," Time Warner CEO Dick Parsons says cautiously, "but with the technology and content that reside around this company, we can create sites and experiences that nobody else can." What he's describing may not constitute "synergy," but it may be AOL's best plan yet.


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