CompuServe Divided
by Randy Befumo (TMF [email protected])

AMERICA ONLINE <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE: AOL)") else Response.Write("(NYSE: AOL)") end if %> and WORLDCOM <% if gsSubBrand = "aolsnapshot" then Response.Write("(Nasdaq: WCOM)") else Response.Write("(Nasdaq: WCOM)") end if %> divvied up COMPUSERVE <% if gsSubBrand = "aolsnapshot" then Response.Write("(Nasdaq: CSRV)") else Response.Write("(Nasdaq: CSRV)") end if %> today in a series of asset swaps that will cement the dominance of both companies in online services and network services, respectively. The deals began when WorldCom purchased CompuServe in a stock swap valued at $1.3 billion. By swapping 0.40625 shares of its own stock for each share of CompuServe, WorldCom gained control of the online service and Internet access provider. WorldCom then went to America Online and traded CompuServe's 2.6 million subscriber online service and $175 million in cash for America Online's ANS Communications subsidiary, further extending WorldCom unit UUNET's lead in the network services and backbone business.

The ramifications to America Online's economic model as a result of this move are both profound and difficult to quantify. The deal gets America Online out of the network building business, allowing AOL Networks Chief Executive Bob Pittman to focus completely on America Online the service. The asset swaps combined with the cash infusion improve America Online's working capital position, clean up its cash flow, and potentially improves its cost structure. America Online will inherit the 2.6 million worldwide subscriber base that was built and managed under the CompuServe brand. The current thinking is to keep this as a separate brand focused on business and technical customers, leaving AOL as the broad-base consumer brand.

Although the CompuServe subscriber base is large and potentially lucrative, the immediate benefits appear to be in the overall company's cost structure. Almost all of the lease payments and costs that had been capitalized associated with ANS and the network disappear from AOL's rather complicated cash flow statement. America Online also gets a favorable five-year deal where it locks in all of the economic benefits it had hoped to get from owning ANS, meaning it gets all the reward with absolutely no execution risk. Furthermore, the company moves to a "portfolio" strategy to solve the access problem, getting service from UUNET, GTE/BBN, and Sprint. This allows it to play the suppliers off one another to get cost breaks and reduces the headache of supporting almost all of the back-end operations to just remembering to write checks at the end of the month.

Of course, no America Online story is ever complete without some complicated accounting. Whatever critics may say, America Online CFO Len Leader certainly earns his paycheck. The sale of ANS is being structured as a five-year sale-leaseback deal, meaning that AOL is selling the network and then leasing back the capacity over five years. Because of this, the company will amortize recognition of the $360 million gain from selling ANS over five years, reducing costs of good sold by $20 million each quarter. Before the number crunchers get too excited, however, they need to remember that this probably will be offset by amortization of the goodwill associated with the purchase of the CompuServe subscribers and a loss of the profits from the ANS unit. However, with the America Online focused on the services side of the business and someone else watching the network ball, it would be hard to imagine not seeing some benefit on the cost of goods sold line at some point in the future.

With $175 million from UUNET (basically CompuServe's $134 million in cash plus some change), $75 million from European media giant Bertelsmann AG for rights to 50% of CompuServe's European business, and the removal of the $37 million in negative working capital ANS Communications had on America Online's consolidated balance sheet, working capital improves by $287 million. Finally having positive working capital again allows America Online some additional financial flexibility and possibly scraps the proposed offering of equity in the Greenhouse venture capital unit that AOL Studios has been contemplating -- particularly given that the price the market was willing to pay was not all that generous. Investors must trust Case & Co. not to blow all of this money in the black hole that AOL Studios could theoretically become, but given the dramatic improvement on costs AOL Networks has seen in the past six months since the arrival of the Bob Pittman, this does not seem to be a serious worry at this point. For evidence of this, just look at marketing spending, which dropped from 40% of revenues to 20%, or look at employee headcount, which did not increase in the fourth quarter after months of explosion.

Enough about the cost structure -- what is the upside from the CompuServe subscriber base? America Online's customers generate $17.25 to $17.50 a month in usage fees (last quarter's $16.47 included large refunds) and $3.47 a month in "commerce" -- a blanket term for merchandise, advertising, and anything else it can sell. CompuServe does $14.40 a month in services and $0.18 a month in commerce, leaving room for a little upside. With an ad sales force already in place, seeing some sales of the CompuServe impressions certainly could be in the cards. Certainly America Online is better positioned than CompuServe was to yield some benefits from these customers. If it can, it will only further distance America Online's lead in the commerce segment. With America Online generating $80 million last quarter in commerce ($36 million in merchandise and $44 million in ads), Yahoo! comes in second or third with only $13.5 million in the same quarter (in spite of the fact that it carries a much higher valuation by any metric).

Once again, America Online has proven that it is willing to turn its financial model on a dime despite its increasing size. Rarely has a company this large been able to deal with changing market dynamics so quickly, although the pricing issue did take a while to finally settle down. As ANS Communications has long been difficult to value, it also may result in an improved valuation for America Online as a whole, as the capital expenditures required to build its business disappear from AOL's books. Although America Online has always reported the company's revenues, because much of its business was building and managing America Online's AOLNet at cost, it was hard to make apples-to-apples comparisons between it and other network services and backbone providers. Using valuations based on multiples to annualized sales or estimated sales that were awarded to UUNET, BBN, and Digex in recent acquisitions to value ANS was hard because so much of its business was done at a discount for its owner, America Online.

The ANS valuation mystery is solved today with the divestiture. Depending on how much you believe a CompuServe subscriber is worth, the real value of ANS was revealed today. By swapping ANS for 2.6 million CompuServe subscribers and $175 million, America Online not only recognized a substantial capital gain on a company it purchased in February 1995 for $20 million in cash and 1.0 million split-adjusted shares, but it also got a sweetheart services deal as well. The five-year, fixed price deal from UUNET to provide its network access could possibly be more valuable to America Online than the CompuServe subscribers and the cash. As demand for "bandwidth" increases at a rapid rate, most industry watchers have projected that prices will increase dramatically over this time period. No matter how you slice it, Case & Co.'s decision to buy ANS in February 1995 has created tremendous value for America Online shareholders, and the company appears to be moving in the right direction to continue this trend.

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