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A Necessary Crisis
May 12, 1997 :: Michael Sippey

Last week AOL announced that for the first time in a year, they turned a profit. In releasing AOL's Q3 (fiscal) 1997 earnings, Chairman Case was downright ebullient: "I think we have turned the corner as it relates to returning to profitability, and we anticipate seeing progress in the future quarters," said Case. "The progress we saw this quarter provides greater confidence in the soundness of our strategy."

I can hear the AOL subscribers muttering under their breath... "Progress? Christ, what about all those damn busy signals?"

(For those who have been under a rock for the past few months: AOL switched to a flat-rate pricing plan, enticing some their users to connect for hours on end, leaving others out in the cold, unable to download their mail or send instant messages.)

The reaction to the "connectivity crisis" at AOL ranged from class-action lawsuits to political posturing to indignant editorializing. Thomas Petzinger, Jr., writing in the Wall Street Journal back in January, argued that Steve Case and company should never have switched to a flat-rate pricing plan. Petzinger maintained that it was actually unethical of Case to offer an incentive to users to "connect ad infinitum to a network that was inescapably finite."

When AOL settled with 36 state attorneys general, agreeing to cap subscriber growth, issue refunds and limit marketing activities, Dennis C. Vacco, attorney general for the state of New York, had some choice words for Case and his management team: "This whole dilemma was a product of their own making."

One could argue, like Vacco did, that AOL was entirely to blame for the crisis that they themselves created. That they should have known better. That they should have had new infrastructure in place before opening the virtual flood gates.

But I wouldn't argue that at all. I would argue that Case made a calculated decision to make the switch when he did.

First, AOL knew it was behind the eight-ball when it came to flat-rate pricing. With more and more content moving to the Web (a la The Motley Fool), AOL had to move to the new scheme in order to compete with independent ISPs and baby bells alike. But slaying the local PPP provider wasn't at the top of Case's agenda; it was a more sustainable revenue model based on advertising and electronic commerce. The flat-rate fee was only a way to keep eyeballs and mouse-clicks online longer.

Second, the company had recently made major changes in the way they report their finances -- ending the practice of capitalizing their marketing expenses in order to boost revenue numbers -- and was under new scrutiny from both Wall Street (who understood the ramifications of this practice all along) and individual investors (who were just realizing that AOL had never actually turned a true profit).

If you go back and read Case's normally inane letters to the AOL "community," you'll notice that he knew exactly what was going to happen to their users when they switched to a flat-rate. "We've seen significant increases in usage in recent weeks," wrote Case on December 2, well before the real problems started to mushroom out of control, "and we realize that the weeks and months ahead will bring even greater surges in usage, as members take advantage of our new unlimited pricing and spend more time online." Case explained to his users that "there is a good chance that you will experience problems from time to time, especially during our peak evening hours. These problems will range from busy signals ... [to] slowness when you're online and attempting to access certain features."

Obviously, AOL users didn't heed his warnings, or didn't even read his message. And unfortunately for Case, the crisis spiraled out of control over the month of January. The busy signals bred frustration, frustration bred lawsuits, and lawsuits bred attorneys general yelling "FRAUD!"

While AOL has come out of this with a bruised reputation and a few months of slowed subscriber growth, they're still on top of their game, and the new earnings figures bear this out. While part of their profitability was due to the settlement-mandated cut in marketing expenses, AOL is actually executing on the strategy which led them to the flat-rate pricing scheme. Revenues from advertising and online transactions tripled in Q3, to $60.7 million (but still a small slice of their $456 million in Q3 revenues). And Tel-Save just paid AOL $100 million to market their long-distance, local and wireless telephone services to AOL customers.

Sure, Case could have managed the crisis better -- offering refunds, capping growth and killing marketing programs before the state politicians got involved. But luckily AOL was hit with a good problem -- too many customers wanting to use the service too often -- and they've used the crisis to invest in much-needed infrastructure. And it's that infrastructure they'll need to support the rapid subscriber growth needed for a business model based on advertising and e-commerce. "They can turn on the engines now," said Alan Braverman, an analyst with Credit Suisse First Boston in the New York Times last week. "They've just scratched the surface with advertising and electronic commerce."

I can hear Case answering those muttering AOL subscribers: "Busy signals? What busy signals?"

 

 

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