Questioning AOL’s Numbers and Clinton’s Effect on the Market

Stock Exchange gives readers a chance to listen in as staff writers Michael Hiltzik and James Peltz argue the merits of individual stocks and other investments.

America Online (AOL)

Mike: We’re starting today, Jim, with America Online, which as you know is the company that has revolutionized Frisbee-playing in this country.

Jim: You mean by inundating us with those free CD-ROMs begging us to sign up for their service?

Mike: Right. It’s a great offer--you can fling them across the park, use them for coasters, put them under your sofa legs, you name it. AOL just started a new mass-mailing this week.

Jim: I’ve always wondered how much it costs them to press those discs and mail them out.

Mike: That’s not an idle point. I would invite anybody to figure out from AOL’s financial statements how it computes its marketing costs these days, and that’s just one of the major issues I have with the company.

Jim: First, let’s give AOL its due.

Mike: For what?

Jim: Yikes! Well, this company survived a lot of doubters and is now the largest Internet service provider around.

Mike: You’ve got the ball, run with it.

Jim: AOL claims to have 14*million subscribers. And it’s noteworthy that this is an Internet company that turns a profit, despite the costs it’s incurred making acquisitions, including buying an old competitor, CompuServe.

Mike: What I find remarkable is how long America Online has survived while being at war with its own customers.

Jim: What?

Mike: I’m serious. Two years ago, we had the great debacle in which AOL cut its rates--offered customers unlimited service, in effect--without being prepared for the tidal wave of heavy usage the change generated. There were outages and lost e-mail, just for starters. It was a disaster.

Jim: I remember. It made all the papers.

Mike: That’s just one reason why there’s a tremendous amount of dissatisfaction among AOL users. Plus, I’d like to know what’s really behind its great subscription numbers--how many loyal subscribers it really has, what its churn rate is, what it costs them to sign people up, and so on. That’s what would tell us how solid its revenue numbers are.

Jim: Are you displacing some other anger, Mike?

Mike: I’ll give you an example, drawn from my own experience. Have you ever tried to cancel America Online?

Jim: No.

Mike: I did. I was a member a couple of years ago, but I decided I didn’t really need AOL because all I wanted was Internet access and I could get that from another service.

Jim: There’s lots of ‘em around, like EarthLink, AT&T;, GTE, Sprint.

Mike: As you know, the arrangement with AOL is that it automatically charges your credit card for your subscription every month. Well, I canceled the service and for six months I was still being billed. AOL eventually withdrew the charges, but wouldn’t you like to bet that I was counted as one of its members for all that time? Worse, a year after we finally resolved that, the company suddenly started billing me again, even though I hadn’t signed up again!

Jim: Are you suggesting that AOL’s revenues might be inflated?

Mike: Let’s put it this way: In AOL’s fiscal fourth quarter, which ended June 30, it reported an increase of 665,000 customers compared with a year earlier, excluding what it got with CompuServe.

Jim: So?

Mike: So that’s almost 70% of the number of subscribers the Los Angeles Times has overall, right?

Jim: But AOL’s circulation area, if you will, is a lot bigger.

Mike: New subscribers? I see a number like that and my first reaction is, “Oh, really?” Are these really new subscribers? Are they free subscribers? After all, the company offers a free month or so to sign up. Is it counting people who simply buy a PC that has AOL’s sign-up icon on the screen? How long will it keep them? And what’s it costing to get them?

Jim: You must admit AOL’s revenue is rising rapidly--it hit $2.6 billion in fiscal ‘98--and it’s producing a small profit.

Mike: The company held off reporting its fiscal fourth-quarter profit until Monday, because it was talking to the Securities and Exchange Commission about how much of a charge it should take for two small acquisitions. The bottom line: AOL earned $7 million in the quarter.

Jim: That’s not much, but it’s enough to keep Wall Street all in a titter over this stock, which has soared from $14 two years ago to around $117 today.

Mike: Let’s look closer at that. AOL has a history of breaking new frontiers, so to speak, with its financial reporting. Back in 1996, it had to take a $385-million charge because of a flap over how it accounted for its marketing costs.

Jim: Costs are one thing. Revenue is another.

Mike: Yes, and I think there’s a tremendous amount of subscriber churn in its figures. I’m worried that one day all these happy AOL investors are going to wake up to another massive restatement because there’s something here that they’re not telling us.

Jim: Somehow I don’t think that’s your last complaint.

Mike: You’re right. Here’s another item I find very suspect. Part of AOL’s pitch to the Street is that AOL subscribers spend a lot more time on AOL than do, let’s say, people who access the Internet through EarthLink.

Jim: That’s kind of meaningless when you’re charging a flat rate isn’t it?

Mike: Meaningless and misleading. It seems to me that it counts you if you’ve logged onto AOL, but even if you wander away and are surfing the Web far and wide, it still counts you as spending time on AOL’s site.

Jim: I assume that’s not considered industry practice.

Mike: What industry? What practice? It’s as if you got in your car in Los Angeles, drove to the Grand Canyon and back, and the California tourist board said you spent the entire week in California. It just ain’t so. So I find it surprising that there are analysts out there who accept these figures.

Jim: They absolutely love this company.

Mike: AOL is the Internet analyst’s stalking horse. They want to love the Internet stocks, but most of these companies have no profit whatsoever. AOL shows a small profit, so everyone points to it as a success story and a model player.

Jim: A mistake. It’s way too early in the Internet’s evolution to take stands like that.

Mike: Especially when AOL not only faces intense competition from other Internet service providers, including wealthy companies like AT&T;, but also competition from other Web sites that have chat rooms and other features just like AOL. This is all going to become a fungible commodity on the Web.

Jim: Even if I’m kinder to AOL and its methodology toward revenue and subscribers, I still have real problems with this stock, and I wouldn’t buy it.

Mike: I’m glad to hear it.

Jim: At the moment, 84% of its revenue comes from subscriber fees, and the other 16% mainly from advertising. But it’s that non-subscription revenue that will be key to the long-term prosperity of Web companies. Until I see AOL put up much bigger numbers there, numbers that are consistently growing, I wouldn’t buy the stock when it’s selling for 117 times earnings per share.

Mike: AOL has occasionally tried new stunts to raise revenue, like selling its membership lists to other companies and imposing advertising screens on its site that interfere with people’s enjoyment of the Web.

Jim: Annoying its customers again.

Mike: AOL, like others, is searching for new ways to raise revenue, but it’s a touchy issue and the company has a membership that’s vigilant about its privacy rights.

Jim: And notably, the one big innovation in this business--the flat monthly price--wasn’t AOL’s idea.

Some Words About the Market

Jim: Rather than review a second stock today, Mike, let’s talk about the overall market and President Clinton. Our readers, no doubt, have heard all the dunderheads on talk shows say that the market is doomed if Clinton quits or gets impeached.

Mike: I think we’ve identified their first mistake: They shouldn’t listen in the first place.

Jim: The problem, of course, is that Washington pundits mostly have political agendas and no knowledge of how markets work. And their ridiculous logic is based on nothing more than the fact that stocks went up during Clinton’s time in office.

Mike: You’re surprised? This isn’t the first time that people thought that the goings-on in a provincial little city on the Potomac River actually have something to do with reality.

Jim: It’s pretty simple. Does the market like guessing about whether Clinton stays or goes? Of course not, no more than we do. And if you’re already inclined to sell stocks, it’s one more reason to go ahead. But will stocks lapse into a sustained dive if he bolts? No way. They might still dive, or might not, but for other reasons.

Mike: Look, one of the few truisms about the stock market is that it’s unnerved by uncertainty. But uncertainty passes. I believe that when markets gyrate to political events--as they did, say, to the ouster of Mikhail Gorbachev--it’s almost always a short-term event. The fact is, news events almost never have the secular influence on markets that economic trends do.

Jim: Hey, watch your language.

Mike: Sorry.

Jim: Think about it. Do the big money managers sell Coca-Cola or Walt Disney on a given day because they’re worried Al Gore might be president in January? Of course not. Hey, Gore can be as ineffectual in fixing the Asian economic mess--the real problem behind the market’s woes these days--as Clinton. The same goes for all the Republicans in Congress.

Mike: What the market is willing to pay for Disney has mostly to do with Michael Eisner’s performance, not Bill Clinton’s. Also, I would question whether there really is a serious constitutional crisis at hand. The country goes on. Clinton for the last six years has been mostly a huge beneficiary of the economic cycle. Now the cycle is turning, and it’s turning while the Clinton impeachment talk is heating up. This is largely coincidence.

Jim: Clinton does get credit for aiding the economic boom by not fiddling too much with taxes and by leaving Alan Greenspan alone.

Mike: And the economic cycle will keep ruling what happens on Wall Street. If people sell stocks now because they’re afraid Clinton will leave office, they might be making the right decision--but for the wrong reason.

Jim: Right. Those talking heads conveniently forget that when the market started dropping in mid-July--a month before Clinton’s situation got really dire--the market was extremely overpriced.

Mike: We’ve discussed this before, that when the market is overpriced, it’s often looking for a pretext to fall. In this case, Clinton serves as the pretext.

Jim: But not the cause.

Mike: Right. Now, if Alan Greenspan or Robert Rubin were to leave ....

Jim: Whoa--let’s hold that for another day.

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Do you have a stock you would like to see discussed in this column? Michael Hiltzik can be reached at michael.hiltzik@latimes.com; James Peltz can be reached at james.peltz@latimes.com. Or write to either at Business Section, Times Mirror Square, Los Angeles, CA 90053.

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Monthly closes and latest: AOL, Monday: $117.13