Dueling Fools

America Online?
Bull Argument

By Jeff Fischer (TMF Jeff)
November 3, 1999

As the century draws to a close, America Online <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE: AOL)") else Response.Write("(NYSE: AOL)") end if %> is the largest Internet service provider (ISP) and the leading content property on the Internet. It has dominated the online landscape since 1996. However, that's in the past. The 1990s are nearly over and done. Kaput. Finis. Sayonara. Forget 'em. Pop the bubbly and kiss 'em good-bye. The 1990s have been fruitful, but they were small potatoes. AOL is already calling the next century "The century of the Internet," implying that the 1990s were only a warm-up for what is on the horizon. Warm-up, indeed.

AOL's recent $130 billion market valuation is a dandy jump-start on the coming "century of the Internet," but if AOL continues to execute, it is only a start. The years 2000 to 2010, 2020, 2050, and beyond promise to be largely Internet-centric for both businesses and consumers. Research firm IDC estimates that 142 million people are on the Internet today. Approximately 14.7% of them access the Web via America Online, while over 75% of them visit or use AOL properties. IDC projects that 500 million people will be online by 2003, an increase of 252% in approximately three years. If AOL maintains its market share, it could have 73.5 million worldwide subscribers, up from 20.9 million today. I don't believe landing this many subscribers is possible in just three years, but if AOL continues to lead, then in five to seven years, yes -- and the stock market always tries to look ahead at least a few years. So, in three years, AOL's stock could be priced for this many eventual subscribers.

73.5 million subscribers sounds inconceivable (the largest newspapers in the country bask in subscriber rates of just a few million), and the financials behind such numbers are equally impressive. Using a member-based valuation method, if we assume that the average AOL subscriber is worth $1,800 to the company over the subscriber's lifetime, AOL will have $132.3 billion in subscriber value alone. And that's just one part of the picture. The lucrative high-margin dollars arrive to AOL via advertising and commerce partnerships. Commanding so many eyeballs, dozens of companies literally throw bankloads of cash at AOL for a tiny piece of AOL real estate. The following is an example of just some clients and what they're paying AOL:

Company                Contract Size
FirstUSA               $500 million
Travelocity            $200mm
American Greetings     $100mm
drkoop.com             $89mm
eBay                   $75mm
Stamps.com             $56mm
Medscape               $33mm
eToys                  $18mm
AOL's advertising and commerce run-rate (which is the last quarter multiplied by four) is $1.4 billion, while its ad and commerce revenue backlog is over $2 billion. This high-margin revenue stream is typically granted about a 20-times-sales multiple by the market. AOL will likely land near at least $2 billion in ad and commerce revenue in 2000. If the company can grow this revenue stream to $7 billion, this theoretically (at a 20 multiple) would add another $140 billion in value. Combined with $132 billion in subscriber value, we would have $271 billion in total value before cash and investments. Assuming share dilution, that price is exactly double the valuation given to AOL today. If AOL's stock could return 100% in three years to five years, it would handily top the S&P 500's average rate of return this century, which has been 100% approximately every seven years.

To achieve a 100% return in three to five years, an investor usually needs to assume a substantial amount of not only short-term risk, but long-term risk (you could be holding a stinker, if you're eventually wrong, for a long time). However, long-term downside risk in AOL's stock at its current price appears limited given the company's momentum in broadband initiatives, subscriber growth, commerce and ad revenue, gross and operating margin, and free cash flow. If AOL can grow earnings at a rate equal to or greater than the Internet's rate of growth, it is difficult to imagine the stock significantly harming a long-term investor's portfolio. Of course, the "if" is a substantial if, even though AOL has all the pieces in place for continued growth.

America Online has the number one online brand in the world, more than three times as many subscribers as its closest competitor; it added a record 1.1 million subscribers in its last quarter (growth here certainly isn't slowing) and it has added a majority of its most lucrative commerce partners in the past year as well. Growth of this important revenue is anything but peaking. It is just beginning.

The beginning, so far, has been picture-perfect. Every single quarter over at least the past three years, AOL's total sales have grown. 
(In thousands) 

Qtr.       1997        1998         1999      2000 
Sep     $349,982     668,000      999,000   1,467,000 
Dec      409,412     723,000    1,148,000    
Mar      450,091     757,000    1,253,000    
Jun      475,515     943,000    1,377,000  
Total  1,685,000   3,091,000    4,777,000
Revenue should top $6 billion in fiscal 2000, while free cash flow -- cash flowing to the company's bottom line which can be used however management pleases -- could expand to nearly $1 billion. Helping to push this number higher is advertising and commerce revenue which, as discussed earlier, is not likely to slow anytime soon. Instead, this revenue should increase as more people subscribe to AOL, and as more and more companies pay AOL dearly for prime real estate in an effort to be noticed in a cyberspace that has become crowded.

Advertising on AOL is said to provide strong results -- strong enough that 90% to 95% of advertising and commerce partners are expected to renew relationships with AOL. With backlog revenue above $2 billion, new advertising partners signing up every month, and with most existing partners in line for a renewed contract, AOL is in one sweet spot. The company earns more high-margin ad and commerce revenue than Yahoo! <% if gsSubBrand = "aolsnapshot" then Response.Write("(Nasdaq: YHOO)") else Response.Write("(Nasdaq: YHOO)") end if %>. Granted, AOL's business platform isn't as light as Yahoo!'s model, but the cash flow from AOL's subscribers (a revenue stream that Yahoo! lacks) has helped fuel growth and, more importantly, helps support AOL's valuation, which stands at three times Yahoo!'s market cap.

AOL's recent $130 billion valuation gives the company tremendous leverage for acquisitions and takeovers in the online market space. AOL is one of the most valuable online-centric companies in the world, behind only such monsters as Microsoft <% if gsSubBrand = "aolsnapshot" then Response.Write("(Nasdaq: MSFT)") else Response.Write("(Nasdaq: MSFT)") end if %>, Cisco Systems <% if gsSubBrand = "aolsnapshot" then Response.Write("(Nasdaq: CSCO)") else Response.Write("(Nasdaq: CSCO)") end if %>, and Intel <% if gsSubBrand = "aolsnapshot" then Response.Write("(Nasdaq: INTC)") else Response.Write("(Nasdaq: INTC)") end if %>. These three companies were recently worth $476 billion, $217 billion, and $242 billion, respectively. AOL, at $130 billion, has the business model to narrow this gap.

My bearish opponent, Rick, has his work cut out for him. I don't believe that he's even a true AOL bear. I believe he's writing the bear side of this duel out of an obligation to make for an interesting duel. Either way, he'll probably be a great voice for the bears. Rick will likely raise the issue of broadband cable access, claiming that AOL is vulnerable to losing market share to it. He'll probably argue that free ISPs are another risk. Finally, the stock's valuation usually receives ribbing from bears. I'll save the rest of my thoughts for the rebuttal.


Next: The Bear Argument