The Trouble With AOL's Hail Mary Assumptions UPDATED

The WSJ has another excellent article detailing the projected financial impact of AOL's plan to eliminate subscription fees for users who already have online access.  (Time Warner has clearly decided to pursue an informal "comments welcome" period before the plan is voted on, perhaps so the Board doesn't approve it and then get laughed out of town). 

According to the article, AOL expects to remain profitable through a three-year transition period, but lose an estimated $2.7 billion in revenue and about $1 billion in operating profit.  To hit these numbers, the company will have to continue growing its advertising business 25%-30% per year AND crank up the advertising operating profit from 17% to 42%.  This latter assumption depends on the online advertising market and AOL's traffic remaining strong (neither of which is a given).

The company's biggest challenge, which the article does not mention, will be to ensure that subscribers who drop their subscriptions but continue to use the service generate as many pageviews as subscribers who keep the service.  Right now, the big flaw in AOL's portal model is that subscribers generate the vast majority of the company's pageviews (mostly through email usage).  If subscribers who quit the service generate fewer pageviews than they did as subscribers, then AOL will have lost two ways, and the free-subscription gambit will have failed. 

The article also does not explain another mysterious assumption of the plan: How AOL expects to boost the profit margin in its remaining subscription business from an estimated 38% today to some 53% in 2009.  Per the article, the subscription business currently generates $4.2 billion in revenue and $1.6 billlion in operating profit (38% margin).  In 2009, the article reports, the company expects revenue of $1.5 billion and operating profit of $800 million (53%).  Given that the main driver of increased subscription profitability--declines in the cost of telecom services--is flattening, how is the company going to increase the subscription operating profit so much while cutting its scale by almost two thirds?

AOL apparently expects the plan to knock its overall operating profit down into the "mid-single-digits."  Given the apparently heroic assumptions above, however, shareholders would probably be wise to brace for losses.  The company is probably still smart to pursue the plan, but shareholders are not likely to get off this easy.

UPDATE:

A perceptive reader pointed out that AOL has another big expense it can slash if it waves the white flag on the subscription business--marketing.  Assuming the company is still spending a big pot of money preaching to deaf ears, this would instantly boost the margins in the subscription business well above the 38% reported by the WSJ.  If the company is still spending, say, $1 billion, and is able to cut this number to zero (unlikely, given that the company will now have to establish a different brand identity, but for the sake of argument...), the profit margin in the subscription business would leap to 62%, which would make a 53% margin on a smaller business seem far more feasible.

Comments

[trollkiller]

First!

[New Troll in Town]

F U K T

[King Troll]

Bitches!

[Victor]

The thing i find most salient about AOL's move is that is clearly shows the death of the subscription model. For years analysts have been praising Yahoo for it's "diversification" through multiple subscription based schemes, and i always thought that was remarkably dim witted of them. Google competed against most of yahoo's products with free ad-supported version. Gmail, the first large shot across the bow, showed that Google could provide a vastly superior service (remember the quality of yahoo mail when gmail was launched? 4mb of space!) for free. That should have been a clear death knell to both Yahoo and AOL's subscription models, but it's only now that AOL is realizing the business truth that you've highlighted Henry. I think Yahoo will go the same way with many of their subscription products, and i think it would be wise of many analysts to reconsider the diversification argument that they cite as a strength for Yahoo.

[ZF]

The real problem with AOL's plan is that none of the pople I know who have dropped their subscriptions this year (which includes me) have visited the site since.

[KK]

Clickfraud for sale on ebay...
http://www.bloggingstocks.com/2006/07/10/click-fraud-for-sale-on-ebay/

[KK]

Do a google search for "traffic exchange" and look at the results..... Very interesting.....And google even displays advertisements advertising.... Here is a sample web site....

http://trafficex.adlandpro.com/

[Frank Barnako]

Dear Henry:

Care to do a phone interview/podcast on this post, this morning? For my Internet Daily column/blog and radio broadcasts?

And what do you think of the thought that removing the thorn in the quarterly report paw, i.e. the sequential drop in subscribers, will help TW focus more on the positives and remove a consistent negative. (http://blogs.marketwatch.com/barnako/2006/07/the_real_reason.html)

Frank