Why AOL's ad woes are unique

AOL Time Warner on Tuesday said it expects its online division's advertising and e-commerce revenue, which largely consists of ad sales, to drop 40 percent to 50 percent in 2003, following equally steep declines posted in the current year. The news helped send the company's stock down some 12 percent in midmorning trading amid a wider sell-off that could sap the strength of a recent rally in technology stocks.

Industry analysts said they were not surprised by AOL's announcement, given the many long-term advertising contracts it inked during the Internet's salad days that are now expiring.

"AOL is definitely an extreme case because they're still winding down the tail end of the big multimillion-dollar boom-time deals," said Jim Nail, a Forrester Research analyst.

Indeed, online stalwarts Microsoft's MSN and Yahoo have recently painted rosy pictures of their online advertising businesses compared with the dire state of AOL's.

In October, Yusuf Mehdi, the corporate vice president overseeing Microsoft's MSN division, touted advertising in a way that recalled the boosterism of 1999. He said that for the 2002 fiscal year, which ended June 30, MSN's online ad revenue grew $40 million. Between June 30 and Sept. 30, it jumped 40 percent.

"We're on a monster roll," Mehdi said. "This is the best-kept secret in the industry, which is that the online ad industry is alive and well and actually kicking butt for a number of companies out there."

For its part, Yahoo posted recent gains in online ad revenue that suggested a turnaround in the market. The company's marketing services revenue, which is mostly from online ads, rose 22 percent year over year to $147.4 million in the third quarter. Still, most of its gains were the product of a deal with pay-for-performance company Overture Services, which reigns over one of the few bright spots in Web advertising. Overture charges marketers for placement in search results.

More broadly, the chasm in advertising performance and predictions among the three top online properties is indicative of a landscape that remains under pressure from larger economic woes. Industry research on the growth of online advertising varies nearly as widely as dot-com earnings reports.

While some industry researchers say that the Net advertising market may see a slight uptick in the fourth quarter from seasonal sales, others say it will likely experience further declines based on three factors.

The first is that modest cyclical growth in advertising will be sucked up by traditional media such as television, which is seen as the last bastion for marketers to reach mass audiences. Traditional marketers are also less likely to allot more money to testing Internet media when budgets are tight. Finally, Net companies are still trying to replace lost revenue from now-defunct businesses.

As a result, Net advertising revenue is expected to reach about $6 billion in 2002, down from the $7.2 billion in 2001 that PricewaterhouseCoopers reported in conjunction with the trade organization Interactive Advertising Bureau. At least one forecaster predicts that the industry will fall further in 2003.

Still, others estimate that Web advertising will come out ahead in 2003. In a report issued this week, industry research firm eMarketer forecast slight annual growth in online ad sales to $6.7 billion, up from an estimated $6.38 billion this year. The company benchmarks its figures on PricewaterhouseCooper's quarterly audits and draws its future estimates based on the predictions of 16 data and research firms, including Forrester.

"Online advertising is finally rebounding due to...an easing of the economic downturn and traditional advertising's better understanding of the Internet's place as part of their total advertising campaign," said David Hallerman, an eMarketer analyst.

Not out of the woods
But because of AOL's ties to many long-term ad contracts that are winding down, and its failure to draw in enough new revenue to make up for the difference, the company is still under pressure.

In the late 1990s, AOL inked multiyear, multimillion-dollar agreements with traditional marketers and dot-coms alike. In one example, it signed a $100 million deal with telecom company Telesave to advertise its service to AOL members over several years.

But as the economy faltered and many dot-coms went out of business, AOL lost these big contracts. In addition, new business sales at AOL have declined.

In the third quarter, AOL reported $321 million in advertising and e-commerce revenue, with $164 million recognized from longer-term commitments and about $157 million from new advertising and e-commerce business.

That compares with the same quarter in 2001, when AOL reported $624 million in total sales from ads and e-commerce, with $431 million recognized from existing contracts and $190 million from new business. Because the amount of money recorded from new business is shrinking, analysts say it's no surprise that the company made such a scant forecast for 2003. In the third quarter, AOL said that e-commerce made up 17 percent of its reported ad and commerce revenue.

"I don't take AOL as a bellwether of online advertising," said Forrester's Nail. "AOL sold a lot of these big multiyear deals and then kind of sat back on their laurels."

Nail said that while AOL built up a reputation for arrogance during the boom times, along with rivals such as Yahoo, the company has failed to change with the austere times. Specifically, Nail said the company has not sold its audience in a way that lets marketers target messages well enough and has failed to innovate fast enough with new advertising technologies. In the meantime, competitors such as Yahoo have restructured and responded more aptly to the market.

"AOL has some mending of fences to do, and it needs to change their ad approach," Nail said.

AOL is positioning itself to do just that. It recently hired new advertising executives such as Lisa Brown, executive vice president of interactive marketing, and placed Vice Chairman Ted Leonsis in charge of improving the customer experience.

Analysts say in the long term, AOL is best positioned for a turnaround because of its relationship with more than 34 million paying subscribers.

In addition, ad dollars will continue to shift online because advertisers always follow audiences, analysts say. Research has shown that people are spending more time online at the expense of other media. And as broadband is installed in more homes, analysts expect the medium to get even better.

"AOL is by far the leading company in advertising revenue, so you can't think the industry can absorb the slack and grow incrementally," said one industry researcher who asked to remain anonymous. The company "is still best positioned to turn it around and improve advertising with its paid users."