The battle for the user's desktop

Usage directly drives the ability to generate these dollars, and the longer the Web site keeps the user, the more opportunities there are to generate revenue.

With an estimated 70 percent of online advertising dollars going to the top 15 most trafficked Web sites, and approximately 85 percent going to the top 25, driving traffic to the sites has become crucial for the financial success and even survival of the Web property.

If we use other forms of media as comparison, we find the dollars concentrated heavily at the top as well. The top ten cable networks account for approximately 68 percent of total advertising revenue, and even in the heavily fragmented magazine business, 22 percent still goes to the top ten properties. So to be financially successful in the so-called new media business, it clearly requires a large mass-market audience or a leadership position in a niche or vertical such as sports, financial content, or travel.

With revenue concentrated so disproportionately at the top, which companies are best positioned to acquire the bulk of these dollars? We believe those players that can effectively control the user's gateways to the Internet are best positioned to become the toll takers along these on-ramps, capturing usage along with all those precious advertising and commerce dollars.

So far, there appear to be two companies emerging as the incumbent contenders for this precious and valuable position: America Online and Microsoft.

Essentially, there are only a few ways to access the Internet: through browsers such as Netscape Navigator and Microsoft Internet Explorer, proprietary software such as AOL 5.0, instant messaging and chat programs such as AOL Instant Messenger and ICQ, and email programs such as Microsoft Outlook.

With rare exceptions, such as the RealPlayer from RealNetworks, AOL and Microsoft own the leading applications used to access the Internet.

Think of it using this analogy: The Internet is a giant shopping mall with only two entrances to get in, one through Kmart and the other through WalMart. Both stores carry almost all the basic commodities the consumer might need (underwear, socks, soap), and unless the shopper has a specific need, the likeliness of that consumer making it to the actual mall is probably small.

What are the basic commodities in the Internet world? The user wants to email and chat with their friends, search for specific information, shop, read the news, get sports scores, check stock quotes, and so on. Owning these services is the key to attracting and keeping the user within a Web site's network, as well as to driving them to other areas of the network.

Both AOL and Microsoft are leveraging their control of the software interface layer to the Internet to initially drive users to these basic services, effectively capturing the user at the first point of entry. Examples of this include adding search, email, and personalized buttons directly into the browsers that direct the user back to parent-owned properties. Search is being integrated directly into the browser command line, further integrating and embedding this basic function. The goal is to make this the most convenient, easiest path for users to accomplish their basic needs.

Think about it for a moment. Before an Internet user can get to another Web site such as Yahoo, Go.com, Amazon, and others, that user must first go through an ever-persistent AOL- or Microsoft-controlled gateway. The whole time, that gateway is competing by offering the same services.

Therefore, AOL and Microsoft's properties enjoy an advantage over their rivals, as the browsing software and other clients have circled traffic back to their respective Web properties. In addition, the two companies have received revenues from other sites looking for additional traffic distribution.

The last ingredient for success comes when an interacting, self-reinforcing community of users forms around a Web network. This is the one element that separates AOL from Microsoft. Although Microsoft, for all intents and purposes, has unlimited financial resources, AOL has the community of users.

With approximately 20 million subscribers and 80 million instant messaging users, AOL is clearly the king. This is a community of users, which, more importantly, is interacting with one another--further building loyalty, creating synergy, and luring new users.

This leverage is already paying off for AOL. The typical AOL user spends nearly one hour per day on the service, 85 percent of which is spent with AOL-owned content and services such as chat, email, shopping, and news. The other 15 percent of time is spent on the vast Web itself, going to sites such as Yahoo, Lycos, eBay, and others.

All told, AOL-owned content and services account for approximately 40 percent of all Internet usage from the home. This is all time that AOL can monetize through advertising and commerce opportunities.

In AOL's case, this successful formula of integrating the gateway, the Web network, and the community has clearly reflected itself in the company's operating metrics. We believe this will continue to be a difficult combination to unseat.

Amazon (AMZN--$80.50) *
America Online (AOL--$118.00)
eBay (EBAY--$145.88)
Infoseek (SEEK--$29.44)
Kmart (KM--$10.00)
Lycos (LCOS--$56.78) *
Microsoft (MSFT--$92.25) *
RealNetworks (RNWK--$100.44)
WalMart (WMT--$54.81)
Yahoo (YHOO--$180.14) *

Prices as of close 10/20/99.
* PaineWebber makes a market in this security.