To: Steve Case
From: James Surowiecki
Date: 1 October 2002
Dear Steve,
So it's true: Your high-profile marriage is about to end in divorce. The rest of the world is still in the dark, but behind the scenes the word is that AOL Time Warner plans to spin off AOL as an independent company.
I suppose I shouldn't be surprised. After all, with Bob Pittman's departure and the much-heralded triumph of the Time Warner side of the company, AOL is just another division, and a struggling one at that. The online service you built was supposed to be the growth engine, providing a steady stream of rising profits for the mature entertainment and media businesses. But now the upstart is growing more slowly than its acquisition, and it's dragging down the entire enterprise. The share price continues to suffer from a synergy discount — the whole is worth less than the sum of its parts. Spinning off AOL will help Time Warner reduce debt, raise cash, and, perhaps most important, restore what must be a battered and embittered morale.
No doubt it's tough to admit the merger failed. I'm sure you're tempted to get out, retire, travel. But this is no time to run. AOL played a crucial, if often misguided, role in the online revolution. Now the nascent world of broadband offers a chance to do it again, and do it right. If you play a smart game, Steve, you have a chance to turn your moribund dialup service into the undisputed leader of the Internet's new era.
Going it alone will actually make your life easier. After all, pairing up with Time Warner undermined your business from the inside out. Rather than pulling the company's Road Runner broadband service under the AOL umbrella, you gave in to institutional inertia and found yourself having to compete with it. The result? Road Runner now has four times as many high-speed customers as AOL. At the same time, the FCC forced Time Warner's cable network to carry competing ISPs as a condition of the merger. Other cable companies didn't have to reciprocate, and they weren't interested in giving one of their chief rivals a better foothold in the broadband market. Independence will put you on a level playing field alongside EarthLink, MSN, and Yahoo! With Time Warner out of the picture, cable and phone companies will be thinking about 35 million customers, not an 800-pound gorilla, when they take your calls. Ditto for the big media companies you'll need to deal with. Sony and Viacom would think twice about partnering with AOL Time Warner. They won't find AOL nearly so threatening.
Take the money from your cash cow and rebuild with broadband at the core.
Then there's the simple issue of meeting expectations. Investors aren't likely to give AOL a rich valuation. That might sound like a negative, but it means you'll be able to live up to the market's expectations even as you make pricey technology investments. After all, even in a miserable ad market, AOL's cash flow last year was nearly $2 billion. If that figure were to fall by, say, 15 percent this year, you'd still take in $1.7 billion in cash. As long as Time Warner doesn't saddle you with too much debt — which it shouldn't, since you had $10 billion in cash and only a billion in long-term liabilities at the time of the merger — you'll be in good shape for a few years.
What you can't do, though, is use that sound financial position as an excuse to continue sitting on your hands. At this point, AOL is a classic cash cow — a successful, mature company with no future. The US dialup market is saturated. The growth rate in the number of residential accounts has dropped for the past three years, and the absolute number of dialup households will decline before long. The choice is clear: You can go on presiding over a lucrative but dwindling business, or you can take the money your cash cow is generating and use it to transform your company. Your best bet, Steve, is to rebuild AOL with broadband at its core.
Your franchise is following customers, not leading them. Well, they want high-speed access.
I understand why you haven't done this already. In the late '90s, AOL looked like one of the strongest businesses ever created. Margins were high, capital expenditures were down, and subscribers were signing up in droves. You were the Internet's kingmaker, with dotcoms begging you to anoint them with a position on your GUI. And the stock market, by giving you such an outrageous valuation, made it seem like your most grandiose dreams would come true. Squandering capital on a technology that people might not want must have seemed like a crazy idea. You built your franchise by following your customers, not by leading them.
Too bad much of your business was a product of the Net bubble. After 2000, it became impossible to play kingmaker; all the would-be kings had gone out of business, taking with them the ad revenue you'd been counting on. At the same time, advertisers began to realize that the online market wasn't as lucrative as they'd hoped. They're still waking up to reality. In the second quarter of 2002, your revenue from advertising and commerce fell by 42 percent. Sanford Bernstein analyst Tom Wolzien has slashed his estimate for this year's ad revenue in half.
Even if the Internet bubble had continued to swell, AOL's days would have been numbered. The reason is simple: It was never really an Internet company. AOL was based on the idea that people needed to live in a halfway house while they became accustomed to the Net. But mainstream users grew more savvy, broadband prices fell, and the advantages of high-speed access became obvious. As a result, your market has started to move on. The number of people who use broadband at home has nearly quadrupled in the past two years, rising from 6.7 million in 2000 to 25 million this year. You've been tight-lipped about how many broadband customers you have, but according to The New York Times, your share of the market is less than 5 percent.
Now, there's no doubt that providing high-speed DSL and cable-modem service yields lower margins than your current business model does. You keep every dime of the $23.90 you charge dialup users, while in the broadband market you have to split your revenue with the phone and cable companies that own the fiber, and they may take more than half. The ad market for broadband is more fragmented than for dialup. On the other hand, broadband has one insuperable advantage: It's growing briskly, while your business is stagnant.
Think of it as the Internet's revenge: It moves so fast that if you try to do an end run around it, you'll find yourself choking in a cloud of virtual dust. After all those years when a 56-Kbps modem was good enough, broadband is finally beginning to fulfill its promise. It no longer takes three months and eight service calls to get a DSL line, and cable companies have wised up to the power of the digital-cable/cable-modem combination. A recent study by the Pew Research Center confirmed what every broadband user knows: High-speed, always-on access brings the Net closer to the center of users' lives. Broadband customers log on more frequently, spend more time online, and download bigger files. That's why the road to broadband is strictly one-way. No one who gets high-speed access goes back to dialup.
The question, then, isn't whether broadband is inevitable. That has already been answered. The thing you ought to be thinking about is, What company will dominate the market? As it stands, the world of high-speed access is tremendously fragmented. Phone and cable companies own the market, while would-be players like Yahoo!, MSN, EarthLink, and AOL itself account for only a couple of million customers. Broadband is a commodity service, and there's little to differentiate one provider from another. But it doesn't need to be that way. The opportunity won't exist for long, but right now a company with the right strategy could emerge with a decisive advantage.
Consider the case of broadcast pioneer David Sarnoff. As head of RCA in the early '20s, Sarnoff founded the radio stations WJZ and WNY to foster the demand for receivers, on which RCA owned the patent. Then he partnered with GE and Westinghouse to create NBC, the first national radio network. The gambit was wildly successful, and radio became America's staple medium. With the advent of television 20 years later, he did it all over again, turning NBC into the first television network. When NBC went on the air, only a few hundred Americans owned TV sets, on which RCA also owned the patent. Needless to say, Sarnoff didn't make money on programming for some time. He didn't follow his customers. He created them. But the lure of programming drove the market, and look where Sarnoff's startup is today.
The familiar lament — voiced often enough by AOL executives — has been that, to the average Joe, there isn't enough content available to make high-speed service worth the price. If that's the problem, the solution isn't to sit around until someone comes up with the goods. Do it yourself. AOL should lead the transition from today's Internet to the digital entertainment paradise we've all anticipated for so long. You know, the one described in those Qwest ads (which may go down in history as Qwest's most impressive accomplishment) with the motel that offers every movie ever made and the jukebox that plays every song ever recorded. And why stop there? As broadband speeds increase, downloadable TV shows and movies are likely to attract a far bigger audience than music does. AOL could become the premier purveyor of videos, software downloads, massively multiplayer games, and whatever else people will pay for.
The media companies have flubbed this transition miserably, alienating customers by creating services like PressPlay, which seems to have been designed not to sell music downloads but to make you think it'd be easier to jump in the car and head to the mall to buy a CD. (There are signs, though, that big media is waking up — like Listen.com partnering with broadband companies and PressPlay allowing CD burning — which is all the more reason for you to act now.) At the same time, Napster's demise has made the whole file-sharing experience less enticing than it was two years ago. Millions of people use KaZaA and Morpheus, but these services are far less reliable and efficient than Napster was. The time is ripe for a universal subscription service that covers both major and indie labels, offers reasonable per-song pricing, and permits CD burning. What's missing is a third-party player with the clout to rope in the major media companies and the technological chops to implement solid digital rights management (or, better yet, find a way to do without). You have the clout, thanks to your existing customer base. As for the technology, well, that's what your current cash flow is for. Come to think of it, the WinAmp guys still work for you, don't they? Isn't it about time you put them to use?
You've already started down this road with MusicNet, offering releases from Warner, EMI, and Bertelsmann. But pitching downloadable recordings to dialup customers is a recipe for irritation, not success. What's more, a music service with three labels doesn't make you a player. It just makes you one of the crowd. Even mighty Time Warner, with pop offerings that range from the Harry Potter movies to HBO to the Red Hot Chili Peppers, is still serving up a small piece of the pie. A user-friendly music/video/software service that includes all the major content providers can turn you into a king (and a kingmaker) again.
The WinAmp guys still work for you, don't they? So put them to work.
Bringing about the digital-media future won't be easy. For instance, an AOL that's dominant in both broadband and media distribution is bound to raise a few eyebrows at the Justice Department. (That's what lobbyists are for.) But distribution doesn't necessarily mean control. It would be a mistake to restrict AOL members' use of the content they download, or to limit their access to other content providers. The Internet's strength is its decentralized, bottom-up structure. Tampering with that invites disaster.
But you don't need to. The payoff for an affordable, reliable digital-media service — one that offers terabytes of stuff you can't get legally right now — will be enormous. Phone and cable companies will be eager to work with you. You'll have no trouble keeping existing customers as they move to broadband, and you'll lure users away from the other providers as well. Best of all, you'll keep all three of your current revenue streams, making money from subscriptions, advertising, and ecommerce.
Pulling off this strategy will require billions in investment and a willingness to gamble that you haven't shown since the mid-1990s, when you spent hundreds of millions on a winning marketing campaign that everyone thought would fail. On the other hand, the underlying principle is identical to the one that guided AOL to such enormous success in the 1990s: You have to offer customers something distinctive if you want to lure them and keep them. Back in its heyday, AOL made its mark not through branding or advertising, but by offering features most people couldn't find — or thought they couldn't find — elsewhere. If your company is going to remain relevant in the broadband era, it has to do this again.
Someone is going to build the digital-media future. If it isn't you, almost surely it will be a certain company based in Redmond. And what could be a more dismal fate for AOL than to be trapped between a dialup past and a Microsoft future?
