Investors worried about free AOL use

NEWS Free Internet access may be a bygone perk of the dot-com bubble, but it appears to be alive and well at the world's largest Internet service provider (ISP), America Online. AOL offers a battery of free promotion and retention programmes, but refuses to disclose how many of its subscribers pay nothing for the service. Now, Wall Street is zeroing in on some financial details that it believes offers a guide to this elusive number, and it doesn't like what it sees. The concern over AOL's non-paying customers comes at a critical time for the ISP. Analysts have been increasingly worried about slowing growth at AOL with many noting that the ISP took longer than expected to reach its 34 million subscriber milestone. This week, AOL announced that it now counts 34 million members, but it took nearly two and a half months to add its most recent million newbies -- more than twice as long as it took to add its last million. In addition, the slower growth at AOL has also raised concerns about the outlook for parent AOL Time Warner, which for the last year has talked about how AOL would turbocharge Time Warner's media properties. Buffeted by an advertising slowdown, AOL Time Warner has drawn fire from Wall Street. Several analysts indicated that they may revise AOL Time Warner's already-lowered 2002 estimates if AOL's subscriber growth continues to slow. The worries over the freebie issue were sparked by a widening gap between the price of an AOL subscription and the average amount the company collects per subscriber. Although the service charges $23.90 a month -- up from $21.95 after a price hike last year -- average monthly subscription revenue per member has hovered between just $17 and $18, according to calculations provided by three Wall Street analysts, figures that are as much as 29 percent below the list price. That doesn't mean that nearly 30 percent of all AOL members are using the service for free: the company has a number of pricing plans and distribution deals, which cut into its margins. But the size of the shortfall offers strong evidence that AOL's much-vaunted growth has increasingly become dependent on free sign-ups, analysts said. "The significance is that (the gap) used to be less than 5 percent two to three years ago," said Michael Gallant, an equity analyst at CIBC World Markets. Other ISPs offer freebies, including Microsoft's MSN, which offers a 90-day free trial as part of an aggressive AOL-poaching programme. But the issue is particularly sticky for AOL these days, because the company's growth rate has begun to slide. The numbers support Wall Street concerns that the US dial-up market may be nearing saturation -- a development that does not bode well for the ISP leader. Indeed, there is no doubt that AOL has increased its reliance on promotions, having increased the time period offered in its ubiquitous free trials from 30 days to 45 days last year. Michael Kelly, the chief operating officer of the AOL unit, declined to break out how may people are using AOL for free. But he said the gap between average subscription revenue per member and the actual subscription price is primarily because of bundling deals with PC manufacturers, which are accounted for differently than ordinary subscriptions. Certain PC makers, such as Gateway, offer free AOL service for certain time periods to new computer buyers. When someone signs up for the AOL deal, AOL pays the PC maker a bounty fee and the PC maker pays AOL a monthly fee up to the amount of an AOL subscription. AOL's revenue is affected in different ways. If AOL's bounty fee equals the PC maker's monthly payments, then the payments cancel each other out. Sometimes, the PC maker's payments exceed AOL's bounty, thus becoming revenue. And if AOL pays a higher bounty than a PC maker's payment, then the loss is recorded as a marketing expense. The end result is more subscribers, but not necessarily more revenue, Kelly said. "This channel has gotten bigger for us," Kelly said. "Each year things change, but the bundled programs have the biggest influence on revenue per member." Subscriber defection, dubbed "churn" in the business, has been a problem at AOL since its inception. Although AOL stopped breaking out its churn numbers many years ago, it has devised a programme specifically designed to persuade newcomers to become paying members. Called its "Member Save" programme, AOL customer service representatives offer free additional months on the back-end to buy more time from people contemplating defection. Programs like Member Save are common in the magazine industry where potential defectors are offered subscription discounts, but AOL has always aggressively thrown free months of service at people. Some former AOL customers said they have been aggressively courted by the ISP when they tried to terminate their accounts, and in some cases were offered free hours as an inducement to stay. A.J. Turpin, a student in San Francisco who recently dropped AOL, said a representative offered two months of free service in a protracted effort to extend the contract. "When I talked to them on the phone, they were insistent that they weren't going to disconnect me, they were going to give me two months free service," Turpin said. "I was insistent. We had that argument four or five times." Not everyone is offered the same deal on the way out, however. Another former AOL member said she received several calls from AOL six months ago when she switched to take advantage of a free offer from MSN, but was not offered any free hours. Still, analysts wonder if AOL's efforts to step up longer free trial periods on the front-end, coupled with aggressive retention efforts on the back-end, could be playing a bigger role in widening the gap between its standard price and the average revenue pulled in per member -- a practice that in effect converts paid subscribers to free, at least over the short haul. Member Save "is certainly is part of it, but frankly we have absolutely no data to track that," First Albany analyst Youssef Squali said. "Their churn numbers, which they don't even release, don't catch those." AOL's Kelly reiterated that bundling deals with PC manufacturers remains the biggest contributor to stagnating revenue per subscriber figures, not the doling out of free hours. "This certainly will have some effect but it's not the biggest," Kelly said. "Part of the Member Save process is that I have you and if you use more sticky apps, your membership will hopefully continue. There are attractive economics here." Whether these free users become permanent ones, there's an advantage in keeping more people on the service. AOL counts its free-trial members in its audience numbers, which appeals to advertisers and marketers. Free trial members can purchase items through AOL's shopping partners and use all of the online service's features such as email and instant messaging. So even though there are millions of people who aren't paying for AOL at a given moment, these same millions are valuable to the service. The issue is of cost, according to David Simons, managing director of institutional research firm Digital Video Investments. It's not about how many people become subscribers, but more about how much total revenue AOL can tap from each subscriber. "The mistake that AOL has made is that it should have stopped emphasising subscriber growth a long time ago," Simons said. "It never weaned investors from the intense focus on subscriber growth when what matters more is revenue per subscriber."

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