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Is AOL underplaying threat of free ISPs?

If recent contract negotiations are any indication, America Online may be more worried than it admits about competition from free Internet service providers.

America Online may be more worried than it admits about competition from free Internet service providers.

In recent contract negotiations, some of AOL's content partners say the online giant has been unusually harsh in demanding limits over links and promotions involving free-ISP competitors.

"If Gay.com is going to promote a FREE ISP, then I have to deny OnQ from linking to their content since this is directly in conflict with AOL," an AOL account manager wrote in an email exchange with lesbian and gay community site OnQ during contract talks. The words "FREE ISP" were capitalized in the correspondence, which was forwarded to CNET News.com by OnQ.

Special report: AOL's squeeze play

Such concern would appear to be at odds with public statements by AOL, whose executives have said repeatedly that the free-ISP business is not a viable one. AOL has continued to stand by its subscription model, arguing that the consumers it wants to target buy services on the strength of the brand, not necessarily based on cost.

"We believe AOL is extremely well positioned in the premium and value segments in the ISP marketplace through its multiple-brand strategy," company spokesman Andrew Weinstein said. "We further feel that there's some significant issues affecting the potential long-term viability of the free-ISP model."

As a result, analysts expressed surprise at AOL's strong stance on free ISPs in its contract negotiations. ISPs such as 1stUp.com, NetZero and Spinway.com have struck deals with some of AOL's biggest competitors to offer free services.

"If they are concerned about a free ISP...it suggests maybe AOL has more reason to be concerned about free players than most people would expect," said Joe Laszlo, an analyst at Jupiter Communications. "Maybe they know something that we don't know yet about how many subscribers they are losing to free ISPs."

In the Internet access market, success is measured by how many subscribers one signs up. But it also is based on how few one loses.

Rather than indicating a direct threat by free ISPs, AOL's concerns may signal trouble among its lucrative roster of content partnerships. Although the OnQ contract was relatively small--it would have cost an estimated seven figures a year to continue--AOL could suffer if others follow suit.

The company has the largest audience on the Internet, with 21 million members on its proprietary online service alone. While the vast majority of its revenues are derived from members paying $21.95 in monthly subscription fees, AOL is trying to balance its subscription income with revenues from content and commerce partnerships.

But this summer, investors began to question whether AOL was being realistic about the free-ISP business. A competitor is a competitor, they say, and success requires finding ways to prevent others from biting off chunks of market share--just like any other business.

"It definitely makes sense that AOL is playing hardball in this area, because free access is eating into their primary business model," said Emily Meehan, an analyst at The Yankee Group. "As dial-up access becomes commoditized and free email becomes commoditized, all of the ISPs--free and for-fee--will have to think of new ways to engage their subscribers to their businesses."

Charles Katz, chief executive of free ISP 1stUp.com, said he considers AOL's concerns a compliment to his business and others like it.

"It's the ultimate form of flattery," Katz said. "Even if companies try to prevent the onslaught, it will eventually become too big for any company to stop."