AMERICA ONLINE Snagged in the net?; AOL: The computer service is twice as big as its two biggest rivals combined. And yet the Internet has cast a shadow over its future.

THE BALTIMORE SUN

A photo caption identifying America Online's president, Steve Case, was mistakenly omitted from an article on the computer service on Page 1D of today's editions.

The Sun regrets the error.

For a man who has lost $3.2 million this month, Steve Case is a pretty calm guy.

The head of America Online Inc. is trying at once to navigate the riptide in the technology stock market and the tidal wave that is the Internet. His company has added 5 million customers in two years, yet his stock is down $41 a share over the past two-plus months.

Sound confusing? It is. AOL has a lot of Wall Street's better minds tied up in knots.

The world's biggest online services company is at a crossroads. AOL dominates its industry, but to a market lately ensnared in the World Wide Web, many question whether the online service industry matters anymore.

"The big issue is, is this a business that's going to go away because of the Internet or is this a business with intrinsic value?" says Lise Buyer, technology analyst for T. Rowe Price Associates Inc. "I believe there's a place for AOL. Like everyone else, I'm having difficulty valuing the stock."

Home computing is changing, almost as fast as things once had to change to make AOL possible in the first place. There is abundant skepticism that AOL can keep up the pace that has taken it from 900,000 customers to 6.2 million since 1994, and there is an array of reasons to take the skeptics seriously -- or not to.

Things also are changing as fast inside AOL as in cyberspace itself. In the past six months, it has hired a president who left four months later, overhauled the software its subscribers use and restructured its pricing in what analysts describe as a bid to hang on to heavy users who find the freewheeling Internet cooler and cheaper.

Insiders have been selling shares, which skeptics take as a sign of trouble. Another sign is that as fast as AOL adds subscribers, it loses them at a slower but still rapid clip, fueling doubts that recent growth figures will pass the test of time.

AOL's biggest competitors are betting that the Internet will change the way they have always done business, a conclusion AOL is resisting.

And short sellers and others say AOL's accounting overstates its profits and question whether there is a real business under all the hype.

"Ask what the bull case is, other than bull generally," demands David Rocker, a New York hedge fund head who says AOL is still one of the market's most overvalued stocks.

AOL stock has fallen to $30 from $71 since May, from $43 since July 1 as technology stocks take the brunt of Wall Street's retreat. Case, AOL's president, took a $2.4 million loss this month on his 186,554 shares of stock. Add his 3 million options and the loss is more like $40 million. Not a great four weeks.

Yet, Case, who turns 38 next month, has been there before. He has weathered similar pessimism ever since the company was founded in 1985.

"I think we've seen this movie before," Case says. "Last year the fear was that Microsoft would crush us. Two years ago, it was media companies like News Corp. Three years ago, it was interactive TV."

There are certain things for which no one will deny America Online credit. Dulles, Va.-based AOL has had a remarkable run. It was founded to serve users of two computer systems people barely remember -- the pre-MacIntosh Apple II and Commodore -- and has outstripped competitors such as Prodigy and CompuServe that were backed by IBM, Sears and H&R; Block.

It expects to have 10 million customers by next year. Its revenues for the nine months that ended in March were $759.4 million. It is an essentially idiot-proof way to exchange e-mail, chat with other users (about 60 percent of the use comes from e-mail and chat), and get news and information.

"There's probably something to the fact that we have more customers than all [other online services] combined," Case says. "Two years ago, we were a distant third."

New Age infotainment

It's cold but true: AOL's business is less about selling high technology than New Age infotainment. It can be used to surf the Net, but the key to understanding AOL's view of the world is to grasp that it works, above all, on the premise that the communications world is changing less -- not more -- than many people think.

The dispute over arguments like these is growing as AOL does. Prodigy and CompuServe have announced that they are moving away from the proprietary software they have used to offer their services in favor of using Internet standards and inviting subscribers to gain access to their service through the World Wide Web.

In essence, they are betting that AOL isn't all that has swiped their market but that the Internet is bowling them over, too. They think they have to ride the emerging wave or else.

The issues, as CompuServe sees it, are customer appeal and cost. They say people are moving to the Internet from online services and add that making an online service work more like a Web site technically will let services work more easily with creative people who write the news, opinion, games and other programming, and cut production costs.

If television terms such as "programming" and "production costs" seem out of place in a story about computers, they're not, because America Online and companies like it aren't necessarily high-technology businesses anymore -- at least not entirely.

Instead, they are crossing the blurry line between technology and programming, a trend highlighted recently by Microsoft Corp.'s forays into online political commentary and a cable news service.

The case for the Web-based online service is an argument that the America Onlines of the world should edge out of the technology business, as such, and leave high-tech to the people making the Internet.

"Instead of spending man-years developing software, we go out and buy the best available," CompuServe spokesman Jeff Shafer says. "We're not competing against [software]. We're competing against things people do with their time, and anything people do to get information and entertainment."

That view wins wide credence on Wall Street. William Smith, who follows CompuServe for Renaissance Capital in Greenwich, Conn., is one example.

"I've heard a lot of reasons why people argue against new technology," Smith says. "People like things as wide open as possible, as cheap as possible."

The argument that the Net is inevitable casts Case in a role he has been forced to play since America Online has become a big company with turf to defend, rather than the visionary upstart trying to persuade people to go online in the first place.

That is, he has been forced to argue in several interviews that technology really isn't changing as fast as people think. Part of AOL's calculation is that the average user won't be a computer nut for a long time yet.

"The last few months have been almost like an inside-the-Beltway phenomenon: People in Washington think issues are important, and when they get out there they find they're not," Case says.

"People in the industry have high-speed Ethernet connections in their offices and don't understand that most people have slow modems and relatively slow PCs in their homes. The reality is, most consumers have 14.4 [kilobits per second] modems in their homes. The Web doesn't work well with 14.4 modems and is barely satisfactory with 28.8," the fastest modems now on the general consumer market.

Besides, Case says, for all the talk that the Internet will be cost-free communication, it isn't yet and may not be going that way.

A typical consumer connection from an Internet service provider (ISP), which sells connections but not content, costs $20 a month. That's more than the average AOL bill of about $18.

And owners of unprofitable Web sites are experimenting with pay-per-hit strategies Case thinks will boost Net costs.

And, although AOL has less information than the Web, what it does have is better organized.

Also, consumers know where AOL's information comes from, which isn't true of some new Web ventures.

'A place for beginners'

"There is still a place for beginners," says Gary Arlen of Arlen Communications Inc., in Bethesda. And, since AOL estimates that 89 percent of U.S. households aren't online, there are still a lot of beginners to attract.

"This idea that AOL is beginning to sink and ISPs are taking over everything is based on a total misunderstanding of the market," says Peter Krasilovsky, also of Arlen Communications.

Nonetheless, AOL has made significant concessions to the way business is done on the Internet. The new software makes it easier to use AOL to get to the Web, and AOL's pricing overhaul is likely to appeal to heavy users most likely to switch to an Internet service provider.

The new price scheme lets consumers pay $19.95 a month for up to 20 hours of AOL and then $2.95 an hour. The old price scheme offered a base rate of $9.95 for five hours and then the hourly rate.

A 20-hour user will save $34.25 a month by switching to the new plan, and light users can stick with the old one if they want to.

Case says the price cuts will boost revenue slightly.

But a lot of skeptics say it's a good thing AOL's customers aren't going to eat up its profits under the new pricing, because there really are no profits there.

The issue is AOL's accounting. AOL pays right away for the software mass mailings it uses to lure new customers but takes two years to charge the expenses off against the earnings it reports.

Because those expenses are more than AOL's paper profits, AOL is actually spending more money than it takes in -- even though it reported profits of $15.4 million in the first nine months of its fiscal year, which ended in June.

The practice is neither illegal nor uncommon. CumpuServe uses it, too, and it is recognized in even the most elementary accounting books.

"If they can't be profitable now, when can they be profitable?" says Ryan Jacob, an analyst with Contrarian Investor Report in New York. "AOL has value, but looking objectively at the potential profitability of this company, it's still way too high, even coming down as much as it has."

A growth machine

AOL still trades at 64 times the earnings analysts project for this year -- even giving AOL the benefit of the accounting doubt, and even after the stock dropped $41 a share. AOL is a growth machine, but can it be a profit machine?

Case just chuckles. No one made money off cellular phones early either, he says, and the people betting against him probably bet against cellular phone pioneer Craig O. McCaw and cable television titan John C. Malone.

"The challenge is not to argue over technology but to leverage it to excite tens of millions of people," he says. "The view we've had for a decade is that a new medium is developing. America Online is in a position to lead that medium, and if we do the stock will reach new highs."

Pub Date: 7/28/96

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