Business Analysis Valuation America Online, Inc.

Study Friday, May 27, 2011

and Case

Group Members: Ahmed Elghannam

Business Analysis and Valuation

Beny Thundiath Hany Ghaith Heather Kanabe 1. America Online, Inc. a. Prior to 1995, why was America Online (AOL) so successful in the commercial online industry relative to its competitors, CompuServe and Prodigy? The online services market was rapidly growing as it approached 1995.i With only three major players, rivalry was not intense. Because AOL had a larger market offering than competitors, it was able to capture more of the available market and increase its relative profits. Given few major firms in the industry, the base price for users was coordinated between the three main firms.ii Due to lack of competition with comparable service, AOL was able to earn substantial commissions of at least 80% of the revenues generated by its sites. AOLs pricing was not only successful due to limited competition. The simplicity of its pricing model, coupled with a premium offering allowed it to secure more early adopters. Though competitors also charged a flat fee of $9.95 for the first five hours of usage, and $2.95 each additional hour, competitors offered more complicated usage fees for premium services and downloading. The pricing structure for AOL services was the easiest for the users to understand in the industry. AOL was an early entrant into a learning economy. Because Internet was new, users needed a friendly interface to help educate them. AOL was able to maintain a differentiated and more diversified product offering than competitors, in one easy to use interface. A full range of interactive services included offerings, designed to meet the varied needs of its four million members.iii Services ranged from online information, networking, education to software. The sites and services offered by AOL were differentiated due to exclusive contracts established with business partners, which did not allow partners to share content through other service providers.iv AOLs extensive research and development helped it deliver products that appealed to users and suppliers in a new learning economy. AOL was able to control its distribution capabilitiesv in addition to the software and content it provided, making it a vertically integrated service provider. AOL offered a

Business Analysis and Valuation

flexible product that worked with Macintosh, Windows 3.xx, and Windows 95. These technology services allowed AOL to adapt its services to changing technology environments, and provide an integrated experience unique in the industry. The success of AOL in relation to competitors was in part due to its position within a network. Online community groups and email connected users. Unique entertainment and informational resources were accessible through the AOL portal. Those who owned sites had exclusive access to the subscriber base of AOL. As an early entrant and with the largest subscriber base, AOL was able to leverage a network effect that provided suppliers and users with a mutual benefit. Prior to 1995 its subscriber base was 4 million out of a total of 8.5 million subscribers. Partnerships with key players like NBC, American Express and Reuters helped build a stronger brand than competitors. As a company it offered valuable ways for users and suppliers to benefit from connecting through an online network. Customer retention by AOL made a significant impact on its leadership in the market. The superior offering by AOL created an implicit switching cost for users, given they would need to disengage from the majority of vendors and fellow users within their established online community. In addition to this AOL made concerted efforts to retain customers, which included financial incentives for employees who retained customers.vi b. As of 1995, what are the key changes taking place in the commercial online industry? How are they likely to affect AOLs future prospects? The entrance of the Internet World Wide Web (WWW) and Microsoft Network (MSN) and the advent of highspeed Internet were key changes taking place in the online industry, as of 1995. High-speed Internet improved the user experience and capabilities of content sites. The new portals offered more control for the content provider and alternative distribution channels to the existing three competitors. Because platforms for content were increasing, so was content suppliers power in the industry. Microsoft carried a strong brand, while the WWW offered complete control and low fees for content providers. The WWW allowed the role of the middleman to shrink, due

Business Analysis and Valuation

to independent designers willingness to build websites at relatively low costs. WWW also expanded the online market internationally. As the online services market grew and more competitors entered the market, price competition increased. Microsoft MSN took only 30% commission in comparison to AOLs 80%. To illustrate the effect of this shift, NBC decided to switch from AOL to MSN. While NBC had many users visiting it on AOL, it was not making much revenue.vii The above noted changes in the industry post 1995 are likely to affect AOLs future prospects by decreasing its power in the marketplace. New options for users may affect AOLs ability to retain customers. The network effect for AOL may decrease as more content providers and subscribers choose alternative Internet portals. More content will likely migrate to the WWW due to its low cost and flexibility. This could negatively affect subscription as a model, due to more content available through a non-subscription portal. AOL will need to make significant adjustments to its business model in order to retain subscribers and other business partnerships. AOL may choose to be more price competitive in online services in order to avoid losing market share. They may also continue to look for alternative revenue sources, including advertising and other services. In order for their online service model to survive, they will need to offer current subscribers something not offered by other service providers. In relation to online services, AOL may step back as the middleman, allowing more flexibility for content providers. AOL may be able to leverage its current partnerships to create new technology opportunities. c. Was AOLs policy to capitalize subscriber acquisition costs justified prior to 1995? Subscribers, acquired through the subscriber acquisition costs, can be expected to produce a future benefit in the form of fees receivable. Although it is difficult to measure the direct future benefit generated by the different marketing initiatives, the acquisition costs can be justified as matching future benefits.

Business Analysis and Valuation

There appeared to be logic, though not clear, that was stated in AOLs accounting policy. The 12-month period of capitalization, though they extended it to 18-month in the case of the starter kits, is relatively short and therefore does not appear to be unreasonable.viii Although the subscriber acquisition was justified, because AOLs closest competitor, CompuServe, did not capitalize subscriber acquisition at the time, AOLs profitability is less comparable when reviewing statements and AOLs income is comparably understated. d. Given the changes discussed in question b, do you think AOL should change its accounting policy as of 1995? Is the companys response consistent with your view? Given the nature of the Internet services industry as of 1995, AOL should either change its policy to reflect the potential decline of the subscription model, or for continuation maintain its policy over the same period of time until there is a posted decline in subscription. Increase in competition and new non-subscription based Internet services, would suggest that subscribership may decrease post 1995. As stated in the case, Forrester Research of Cambridge, Mass., predicted that the big three, America Online, CompuServe, and Prodigy, would continue to add subscribers only through 1997. After that, Forrester predicted, it would be all downhill for the big three.ix Analysts also suggested that, lower gross margins in the future as subscribers continued to transition to higher-speed access and as AOL introduced a heavy-usage pricing plan in response to Microsofts lower per-hour pricing.x The changes in policy by AOL in 1995 and moving forward do not reflect the evolving marketplace, but rather depict more aggressive capitalization of expenses. Given it is unclear whether subscribers will be a major source of revenue going forward, it would not make sense to extend the period from 12 and 18 months to 24 months. It appears that the increase in projected lifetime revenues to $714 from $667 of subscribers is due to factors other than improved retention, and cannot be ensured going forward. The change of accounting policy by AOL to 24 months for both marketing initiatives seems arbitrary and

Business Analysis and Valuation

decreases the validity of the estimation process used to quantify future benefit of costs. e. What would be the effect on AOLs 1994 and 1995 ending balance sheets if the company had followed the policy of expensing subscriber acquisition outlays instead of capitalizing them? What would be the effect of expensing subscriber acquisition costs on AOLs 1995 income statement? By expensing the subscriber acquisition outlays, the value of deferred subscriber acquisition costs would be removed from the asset section in the balance sheets, which would reduce the total value of assets. There would be an equivalent decrease in the stockholders equity. The new value of total assets for 1994 and 1995 would be $128,192 and $329,235 respectively. The effect on the balance sheet is a reduction in total assets and increase in accumulated deficit of $26,392 and $77,229 for 1994 and 1995 respectively. The amount reduced from the assets section would be included in operating expenses, reducing the net income. The reduction in net income results in the decrease in stockholders equity. The effect on the 1995 net income would be an increase in net loss by $77,229, resulting in a final net loss of $110,876 as described in below sheet.

CONSOLIDATED BALANCE SHEETS (Amounts in Thousands, Except Per Share Data) June 30, 1995 ASSETS Current assets: Cash and cash equivalents Short-term investments Trade accounts receivable Other receivables Prepaid expenses and other current assets Total current assets Property and equipment at cost, net Other assets: Product development costs, net $45378 18672 32176 11103 25527 132856 70466 18914 1994 $43891 24052 8547 2036 5753 84279 20306 7912

Business Analysis and Valuation

Deferred subscriber acquisition costs, net License rights, net Other assets Deferred income taxes Goodwill, net LIABILITIES AND STOCKHOLDERS EQUITY Current liabilities: Trade accounts payable Accrued personnel costs Other accrued expenses and liabilities Deferred revenue Line of credit Current portion of long-term debt and capital lease obligations Total current liabilities Long-term liabilities: Notes payable Capital lease obligations Deferred income taxes Deferred rent Total liabilities Stockholders equity: Preferred stock, $.01 par value; 5,000,000 shares authorized, none issued Common stock, $.01 par value; 100,000,000 shares authorized, 37,554,849 and 30,771,212 shares issued and outstanding at June 30, 1995 and 1994, respectively Additional paid-in capital Accumulated deficit Total stockholders equity

0 5537 11479 35627 54356 $32923 5

0 53 2800 12842 0 $12819 2

$84639 2829 23509 20021 484 1830 133312 17369 2127 35627 85 188520 0

$15642 896 13076 4488 1690 597 36389 5836 1179 12842 41 56287 0

375 251539 (11119 9) 140715 $32923 5

308 98836 (27239 ) 71905 $12819 2

Krishna G. Palepu and Paul M. Healy: Business Analysis & Valuation Using Financial Statements, Text and Cases, Second Edition, Pg. 58. ii Ibis., Pg. 35. iii Ibis., Pg. 55. iv Ibis., Pg. 57. v Ibis., Pg. 58. vi "AOL". Better Business Bureau. Retrieved 2008-01-22. "Cancelling AOL". insignificantthoughts.com. 13 June 2006. Retrieved 28 November 2010. vii Krishna G. Palepu and Paul M. Healy: Business Analysis & Valuation Using Financial Statements, Text and Cases, Second Edition, Pg. 59. viii Ibis., Pg. 76, 77. ix Ibis., Pg. 60. x Ibid.