Is FAC Equities analyst James Sadler just saying what Wall Street is thinking about America Online (NYSE: AOL), but afraid to put down on paper?
That question is worth asking following Sadler's downgrade of AOL to "neutral" from "buy" on Wednesday because of concerns about pricing pressure. No one heard Sadler's downgrade and AOL shares (chart) actually went up, but the analyst may be on to something.
Sadler's downgrade came on a simple premise: Free Internet service, a soon-to-be aggressive MSN and bundling of Net service in telecommunications and computer packages will hamper AOL's ability to charge subscribers $21.95 a month for service.
| AOL: Pricing pressure ahead? |
The bulls on AOL will say the company can make up the subscriber revenue elsewhere via e-commerce and advertising. But how many more banners can users take? Other analysts will cite the AOL "value proposition," but pricing pressure still hurts.
"It's a trend I don't think I can ignore," he said. "It's loud enough now."
Sadler said three months ago the free Net service and bundling agreements didn't seem to be getting traction, but it's a different story now. NetZero, a soon-to-be-public free ISP, has been gaining users. AT&T (NYSE: T) and Qwest Communications (Nasdaq: QWST) are bundling Internet access to reduce long distance churn and PC makers such as Gateway Inc. (NYSE: GTW) are becoming de facto ISPs on the cheap.
"These people are not going to give up," he said.
Sooner or later pricing pressure will hit AOL and Sadler hinted that the professional investors are already on to the story.
To put Sadler's downgrade in perspective consider this: He's out on a limb with this call. According to Zack's Investment Research, 38 analysts rate AOL at least a "buy." One other firm, Brown Brothers Harriman, rated AOL a "neutral" in March. The Brown Brothers analyst didn't return calls from ZDII.
Now Sadler isn't predicting the demise of AOL, but he is matching his rating to the risk. Sadler said AOL's revenue projections and valuation need to be reconsidered. When he ran the numbers AOL's premium was too steep. He also expects Mindspring (Nasdaq: MSPG) and Earthlink (Nasdaq: ELNK) to see pricing pressure, but AOL (financials) was the most overvalued of the ISP bunch.
Sadler's new price range for AOL: $85 to $106, down from $118 to $139. Some analysts have price targets as high as $200.
Sadler didn't change his subscriber growth figures, but did cut revenue per subscriber by about 50 cents to $1 for each customer. He said he expects some case-by-case discounting from AOL even though it may not officially cut prices for its 18 million plus subscribers.
The analyst noted that there are serious questions about NetZero such as whether ads can support an ISP and the company's churn rate. But the growth is there. From NetZero's October 1998 launch and August 31, the company had 1.68 million users registered for our service, according to regulatory filings. During August, about 891,000 of these users accessed the service and were delivered 1.15 billion advertising impressions. NetZero is scheduled to go public Sept. 24.
For the quarter ending June 30, NetZero sales were $3.7 million with a loss of $8.2 million. For the quarter ending March 31, sales were $781,000 with a loss of $5.1 million.
And if NetZero doesn't hurt AOL perhaps MSN will. MSN, with former Silicon Graphics chief Richard Belluzzo at the helm, will try to undercut AOL. Microsoft didn't bring Belluzzo over to maintain the status quo. "The real wild card is what MSN is going to do," said Sadler.
It is quite possible that much of Wall Street knows about the pricing pressure threat despite analysts' reluctance to downgrade the stock.
Here's a sampling of the standard research note double-talk:
"Any deterioration in subscriber pricing or a significant loss of subscribers could dramatically impact future revenue," said James Preissler, an analyst with PaineWebber, in a note reiterating a "buy" rating and a $215 "conservative" price target.
Merrill Lynch analyst Henry Blodget maintained AOL at the equivalent of a "strong buy" and a price target of $150, but noted that pricing pressure could reduce upside to current Street forecasts.
For Sadler, the current analyst double-talk plays down the pricing pressure risks too much. "It's time we recognized we're analysts and not corporate mouthpieces," he said.