The Engine Stalls At AOL

By Frank Gibney Jr. And Daniel Eisenberg Dulles

Six years ago, Bob Pittman traded away his job as CEO of the world's largest real estate company to rescue a struggling Internet company that many critics had already written off. He did that and more, using his marketing wizardry to turn America Online into a new media powerhouse, big enough to eventually swallow an old media standard bearer called Time Warner. He became a self-designated prophet of 21st century success: AOL was going to rocket Time Warner into a brave new world, delivering music, movies and you name it, anywhere, anytime--and of course make a killing in the process.

But last week Pittman had to be called on once again to save AOL, which is beginning to look like the media giant's albatross. After eagerly devouring Pittman's hype just a year ago, investors and critics now feel woozy. Incoming AOL Time Warner CEO Richard Parsons, 54, clearly felt that nobody could clean up the mess better than Pittman, which is why he asked his top deputy to go back to Dulles, Va., on a new rescue mission. "AOL is our biggest problem, and so we're putting our best fighting general on it," says Parsons, who was designated CEO when Gerald Levin abruptly announced his resignation last December.

Pittman takes over from Barry Schuler, the former tech entrepreneur who has run AOL since the merger in January 2001 and will now head a new interactive services division. Although Pittman, 48, is known as an agile manager with an uncanny ability to build big consumer brands, this is the Mississippi native's biggest test. He must restore AOL's luster and regain the trust of colleagues, business partners and, most important of all, Wall Street.

The fact is, two years after the merger was announced, AOL Time Warner's top brass is being forced to prove the decision was not a mistake. Despite its powerful brand and unrivaled global member base of 34 million, the AOL division has seen its once stratospheric subscriber growth slow, its ad revenue fall and its international operations bleed money. The much ballyhooed broadband move--in which networked homes will enjoy high-speed connections to movies and music whenever they want--is off to a rocky start. Any delay is crucial to consumers eagerly anticipating the broadband revolution, because if AOL, with all its affiliated cable systems and entertainment properties, can't deliver those services, who can? Microsoft? Comcast? Rupert Murdoch?

The AOL service's woes have infected all of AOL Time Warner, whose stock is the third most widely held in the U.S. By the end of last week, those shares had dropped to $20.10--wiping out nearly two-thirds of the market value of the combined companies since their merger was announced in January 2000. Several Wall Street analysts estimate the company's cable, entertainment and publishing divisions (which include CNN, Warner Bros., Warner Music and Time Inc., the parent company of this magazine) are worth about $19 a share. That leaves AOL near zero. When it reports its first-quarter financial results next week, AOL Time Warner will take a write-down of $54 billion--the biggest such charge in U.S. history--to reflect the decline in value of the combined company. This meltdown has revived questions raised by some Time Warner division heads in the months following the merger: Why was a solid company sold for overinflated AOL stock?

In part, the AOL division is a victim of the lofty expectations generated by its successes in recent years--and the hyperbole of some of its executives. After the online service's ad and e-commerce revenue doubled in 1999 and nearly doubled again in 2000, executives--led by Pittman--declared that AOL could power AOL Time Warner to a 33% annual growth in cash flow, even during a 2001 that was clearly shaping up as a recession year.

But while managers in New York City were trumpeting these goals, the folks at the AOL division's headquarters in Dulles were overwhelmed by them. Even before the merger was finalized, many of AOL's top managers and technologists were retiring--either formally or in practice--on the immense wealth they amassed before the dotcom bubble burst. Pittman, meanwhile, moved to New York to help run the parent company. And founder Steve Case, now chairman of AOL Time Warner, stepped back from day-to-day responsibilities, in part to spend more time in California with his brother Dan, who is battling brain cancer.

That left Schuler--who had never managed anything larger than the 100-person software start-up that he sold to AOL in 1995--in charge of a fast-swelling staff of 15,000 and $9 billion in annual revenue. Instead of setting strategic priorities, Schuler and his lieutenants bounced between brainstorming sessions for soon-to-debut products like universal messaging and agonizing meetings over how to fulfill short-term earnings goals. One executive bemoans that at the old AOL: "Our great strength was keeping it simple, the goals clear and everyone pulled together. We really ended up losing our focus."

In the first move to restore some discipline, AOL Time Warner last fall sent chief financial officer Michael Kelly from the New York headquarters to become the AOL division's chief operating officer. Kelly found what a senior executive refers to as a "big sandbox," in which in the name of synergy, it seemed as if anyone with an idea was suddenly proposing grandiose new projects with Time Warner divisions. "People are doing crazy stuff and wasting money," says the executive. "Someone has to set some priorities." Case, 43, says ruefully that rather than speeding AOL's move into the broadband age, "the merger actually slowed us down."

Case is confident that AOL will haul itself out of the ditch; he points to a history of unfulfilled predictions of its demise. During the winter of 1996, just before Pittman arrived, the company was dubbed America on Hold because its servers couldn't handle the dial-up volume. But AOL invested heavily in fail-safe server technology and launched a massive marketing effort. "I've seen this movie a lot," says Case, who recently bought an additional 1 million shares of stock at $24 a share, after selling twice that amount early last year at a significantly higher price. "I kind of like being the underdog again. That's when we've always done our best work."

The situation is serious enough, however, that Case says he will rely more heavily on his founding fraternity to set the company right. AOL's cash cow is its 26 million U.S. subscribers, most of whom pay $23.90 a month for AOL's dial-up service. Almost half of that subscription revenue represents pure profit. But the U.S. dial-up market is already close to 60% saturation and isn't expected to hit 70% before 2005. AOL subscriber growth this year is estimated to drop to about 10%, just a third of its torrid pace in 1999.

The AOL division's long-term-growth gambit is to attract as many of its dial-up customers as possible into the promised land of broadband, where they would pay more--eventually as much as $200 a month, in Pittman's rosy scenario--for a variety of on-demand services, from wireless instant messaging to the ability to listen to Norah Jones or watch A Beautiful Mind anytime they like.

But delivering those services--and doing so at a profit--is proving a vastly more complex business proposition than anyone imagined. As the ongoing battle over music and video downloads suggests (think Napster), success in a broadband world requires solving complex questions about copyrights and digital encryption. Few executives, even at AOL Time Warner's movie and music divisions, are ready to open their treasure troves to the threat of piracy in an online, on-demand world. The broadband business also requires AOL to pay a cable or DSL provider for access to the pipes that reach customers' homes--at least in the 80% of the U.S. where Time Warner Cable doesn't control the cable systems--and to figure out a way to share additional revenues with a disparate array of partners. Such deals have become especially imperative since December, when AOL Time Warner lost out to Comcast in the bidding for AT&T's 14 million cable customers.

All this adds up to a grim reality: until AOL can offer easy access to premium content such as movies and music on demand, not enough customers will pay even the $55 a month it charges today for its broadband service. Those who do--the early adopters--are actually cutting into AOL profits. Every time one of its dial-up customers shifts to broadband, the AOL service goes from a nearly 40% profit margin to one potentially as low as 10%--mainly because it has to share broadband revenue with cable partners.

Can Pittman put AOL back on track? His appointment was lauded among employees who view him as an impassioned leader with a down-home style that reflects his Southern roots and a long stint in the music business. (After an early spell in radio, Pittman went on to found MTV and VH1 and did a stint at Time Warner before joining real estate firm Century 21.) He flies his own jet and has houses in New York, Colorado and Jamaica. But unlike many other AOL millionaires who spend more time with their toys than at the office, Pittman is committed to the company (although his wife Veronique and their two young children were not thrilled that he will be working two jobs, one of them in Virginia).

Both Parsons and Pittman have insisted that AOL's troubles are not as dramatic as the headlines suggest. Growth may have slowed, but it hasn't vanished. Pittman has told AOL division staff members to refocus on the service's core mission, "figuring out what's important to people and how to make it more convenient for them to do that online."

But his immediate priority is to attract more advertising. If it weren't for the $130 million that AOL's sister divisions plowed into promoting their brands on the service during the fourth quarter, ad revenue would have plunged 26% instead of just 7%. In fact, AOL Time Warner is one of its own biggest advertisers. Many of the New Economy companies that used to advertise on the AOL service are either bankrupt or close to it. And although consumers are spending more and more time and money on the Internet, Fortune 500 companies and their agencies remain doubtful of the impact of online ads.

AOL executives say that by using its online network to build buzz for such hugely successful Warner Bros. films as Harry Potter and Lord of the Rings, the AOL service has proved its worth. Likewise, AOL's revamped music channel--one of its hottest content areas, drawing 9 million visitors a month--is fast becoming a key promotional vehicle in the record business..

But to draw more advertising, the AOL division is going to have to change its notorious our-way-or-the-highway culture. The AOL service's business partners, suppliers and advertisers trade stories of sitting around tables listening to AOL executives yammer on about who is wealthier or has a nicer private jet. To his credit, Schuler had started an effort to inject a little humility. One might expect that a battered stock price had already done that. "They're still copping attitude and alienating people," says an ad executive. Managers at a telecom giant found AOL so uncompromising on a recent contract that they are shopping their business elsewhere.

For all its troubles, the AOL service, which accounts for nearly a quarter of the media giant's cash flow, is a global leader whose 34 million subscribers dwarf the 8 million of its nearest competition, Microsoft's MSN. None of AOL's competitors offers a service that so successfully combines simple e-mail, instant messaging and chat. And no one matches AOL's unique system of parental controls, which makes it the family service of choice. But to keep its user base growing, AOL has been giving away more subscriptions--one reason its revenue per user has stayed flat, despite last year's $2 price increase. Kelly maintains that the trial offers are worthwhile because nearly three-quarters stay on as full-paying members.

Though AOL says its members have never been happier with the service, independent surveys show that dissatisfaction is on the rise. In one by the Yankee Group, a Boston, Mass., research firm, AOL fared worse than the industry as a whole at "providing value for the money." Last fall, in a Consumer Reports look at Internet service providers, AOL came in last in connection reliability, far behind leaders EarthLink and AT&T WorldNet. To many, AOL seems more and more like a carnival barker, flashing pop-up ads in their faces. Pittman last week indicated to colleagues that he considers the pop-up ads out of control and will move quickly to fix the problem.

AOL believes it can still count on users' loyalty. Plans are in the works to further segment AOL, so that "professional" subscribers would get more features for their money, while the budget-conscious would pay less. And AOL will soon introduce a variety of multi-user family packages. But so far, at least, subscriber "stickiness" may have less to do with satisfaction than with complacency. As Standard & Poor's analyst Scott Kessler puts it, "Nobody wants to change their e-mail address." The competition is working hard to get those AOL subscribers. Microsoft, which banished AOL from its Windows XP desktop last summer, is investing heavily in new features for its MSN service and generally getting good reviews.

To help turn things around, the AOL service has forged a few promising partnerships with hardware and software powerhouses, including Sony and Apple. Online retailer Amazon has contracted to provide AOL with its powerful shopping search technology, beginning this fall. But AOL hasn't yet made the most crucial kind of deal--with another cable provider. After investing billions to upgrade infrastructure, rival cable providers aren't ready to hand over their lucrative customer relationships. AOL will soon enjoy access to all of Time Warner Cable's 13 million homes, but that's less than 20% of the total market. Its high-speed service, now offered as an option on the Baby Bells DSL service and 20 of Time Warner Cable's markets, has garnered only around 500,000 paying customers, about 5% of the 10 million U.S. residential broadband users. Part of the problem is that AOL charges around $55 a month, compared with $30 to $50 for rival cable and telephone companies. Even on Time Warner's cable systems, the cheaper high-speed isp that the cable guys built before the merger, called Road Runner, has nearly 2 million customers and is reportedly still outselling AOL.

The AOL division's quest for rapid growth overseas, meanwhile, has been slow and costly. AOL Europe lost $600 million last year, even as AOL was forced by contractual obligation to buy out the 50% stake in that business owned by German media giant Bertelsmann. The price--$7 billion--had been set at the height of the Internet bubble and represents about twice what the Bertelsmann stake is worth today.

That sort of liability is just part of a debt burden that, combined with the current ad recession, hampers AOL Time Warner's ability to pay for new cable assets or another TV network. In fact, analysts are concerned that its balance sheet may put the company at a disadvantage when competitors like Microsoft are hoarding cash to fight tomorrow's new media battles.

Throughout AOL Time Warner, morale is slipping along with the stock price. People gossip about Pittman's stock sales--he sold 1.5 million shares last year for $70 million and now holds only about 13,000--and wonder how he will handle two full-time jobs. Company sources say there may be more executive moves as early as May, when Parsons formally succeeds Levin; while some speculate that if Pittman is successful he could be back at corporate full-time in a matter of months, others say that if he can't show progress at AOL by year-end, he may leave the company altogether.

For his part, Steve Case is confident in his former deputy and their joint vision. "The AOL business is still the crown jewel in the AOL Time Warner portfolio," Case says. "It will surprise the world yet again by raising the bar and inspiring imagination."