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Free AOL use sparks new worries

Though America Online won't say how many subscribers pay nothing to use the service, some analysts are closing in on a figure--and they don't like what they see.

Free Web access may be a bygone perk of the dot-com bubble, but it appears to be alive and well at the world's largest Internet service provider, America Online.

AOL offers a battery of free promotion and retention programs, but it refuses to disclose how many of its subscribers pay nothing for the service. Now, Wall Street is zeroing in on some financial details that it believes offer a guide to this elusive number--and it doesn't like what it sees.

The concern over AOL's nonpaying customers comes at a critical time for the ISP. Analysts have been increasingly worried about slowing growth at AOL, with many noting that the ISP took longer than expected to reach its latest subscriber milestone. This week, AOL announced that it now counts 34 million members, but it took nearly two-and-a-half months to add a million newbies--more than twice as long as it took to add the previous million.

In addition, slower growth at AOL has raised concerns about the outlook for parent AOL Time Warner, which for the last year has talked about how AOL would turbocharge Time Warner's media properties. Buffeted by an advertising slowdown, AOL Time Warner has drawn fire from Wall Street. Several analysts have indicated that they might revise AOL Time Warner's already-lowered 2002 estimates if AOL's subscriber growth continues to slow.

The worries over the freebie issue were sparked by a widening gap between the price of an AOL subscription and the average amount the company collects per subscriber. Although the service charges $23.90 a month--up from $21.95 after a price hike last year--the average monthly subscription revenue per member has hovered between just $17 and $18, according to calculations provided by three Wall Street analysts. Those figures are as much as 29 percent below the list price.

That doesn't mean that nearly 30 percent of all AOL members are using the service for free: The company has several pricing plans and distribution deals, which cut into its margins. But the size of the shortfall offers strong evidence that AOL's much-vaunted growth has increasingly become dependent on free sign-ups, analysts said.

"The significance is that (the gap) used to be less than 5 percent two to three years ago," said Michael Gallant, an equity analyst at CIBC World Markets.

Other ISPs offer freebies, including Microsoft's MSN, which offers a 90-day free trial as part of an aggressive AOL-poaching program. But the issue is particularly sticky for AOL these days because the company's growth rate has begun to slide.

Leaning on promotions
The numbers support Wall Street concerns that the U.S. dial-up market may be nearing saturation--a development that does not bode well for the ISP leader. Indeed, there is no doubt that AOL has increased its reliance on promotions, having extended the time period offered in its ubiquitous free trials from 30 days to 45 days last year.

AOL's growth spurts
Wall Street worries that AOL took too long to report its latest subscriber milestone and that the total in April won't measure up to previous quarters.
Date reported Total # subscribers # added from previous quarter
Jan 2000 20.5 million 1.8 million
Apr 2000 22.2 1.7
Jul 2000 23.2 0.992
Oct 2000 24.6 1.4
Total subscribers added in 2000: 6.2 million
Jan 2001 26.7 million 2.1 million
Apr 2001 28.8 2
Jul 2001 30.1 1.3
Oct 2001 31.3 1.3
Total subscribers added in 2001: 6.5 million
Jan 2002 33.2 million 1.9 million
Mar 2002 34 0.8
Source: AOL Time Warner earnings reports and press releases
J. Michael Kelly, chief operating officer of the AOL unit, declined to say how may people were using the service for free. But he said the gap between average subscription revenue per member and the actual subscription price primarily resulted from bundling deals with PC manufacturers, which are accounted for differently than ordinary subscriptions.

Certain PC makers, such as Gateway, offer free AOL service for certain time periods to new computer buyers. When someone signs up for the deal, AOL pays the PC maker a bounty fee, and the PC maker pays the ISP a monthly fee up to the amount of an AOL subscription.

AOL's revenue is affected in different ways. If its bounty fee equals the PC maker's monthly payments, then the figures cancel each other out. Sometimes the PC maker's payments exceed AOL's bounty and become revenue. If AOL pays a higher bounty than a PC maker's payment, then the loss is recorded as a marketing expense.

The end result is more subscribers, but not necessarily more revenue, Kelly said.

"This channel has gotten bigger for us," Kelly said. "Each year things change, but the bundled programs have the biggest influence on revenue per member."

Subscriber defection, dubbed "churn" in the business, has been a problem at AOL since its inception. Although the service stopped breaking out its churn numbers several years ago, it has devised a program to persuade newcomers to become paying members.

Called its "Member Save" program, AOL customer service representatives offer free additional months to buy more time from people contemplating defection. Programs such as Member Save are common in the magazine industry, where potential defectors are offered subscription discounts. Likewise, AOL has always aggressively thrown free months of service at people.

Some former AOL customers said they were heavily courted by the ISP when they tried to terminate their accounts, and in some cases they were offered free hours as an inducement to stay.

"On the phone, they were insistent"
A.J. Turpen, a student in San Francisco who recently dropped AOL, said a representative offered two months of free service in a protracted effort to extend the contract.

"When I talked to them on the phone, they were insistent that they weren't going to disconnect me. They were going to give me two months free service," Turpen said. "I was insistent. We had that argument four or five times."

Not everyone is offered the same deal on the way out, however.

Another former AOL member said she received several calls from the ISP six months ago when she switched to take advantage of free service from MSN, but she was not offered any free hours.

Still, analysts wonder if AOL's efforts to step up longer free-trial periods for new members, coupled with aggressive efforts to retain subscribers, could be playing a large role in widening the gap between the service's standard price and the average revenue pulled in per member--a practice that in effect converts subscribers to free users, at least over the short haul.

Member Save "certainly is part of it, but frankly we have absolutely no data to track that," First Albany analyst Youssef Squali said. "Their churn numbers, which they don't even release, don't catch those."

AOL's Kelly reiterated that bundling deals with PC manufacturers remains the biggest contributor to stagnating revenue per subscriber figures, not the doling out of free hours.

"This certainly will have some effect, but it's not the biggest," Kelly said. "Part of the Member Save process is that I have you, and if you use more sticky apps, your membership will hopefully continue. There are attractive economics here."

Regardless of whether free users become permanent ones, there's an advantage in keeping more people on the service. AOL counts its free-trial members in its audience numbers, a technique that appeals to advertisers and marketers. Free-trial members can purchase items through AOL's shopping partners and use all of the online service's features such as e-mail and instant messaging.

So even though there are millions of people who aren't paying for AOL at a given moment, these same millions are valuable to the service.

The issue is one of cost, according to David Simons, managing director of institutional research firm Digital Video Investments. It's not about how many people become subscribers, but more about how much total revenue AOL can tap from each subscriber.

"The mistake that AOL has made is that it should have stopped emphasizing subscriber growth a long time ago," Simons said. "It never weaned investors from the intense focus on subscriber growth when what matters more is revenue per subscriber."