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AOL sheds big problem: networks

The biggest potential for AOL's growth in the three-way deal could come from what it is giving up: its troublesome networks.

If the three-way deal among WorldCom (WCOM), America Online (AOL), and CompuServe (CSRV) goes through, AOL will go from being the 500-pound gorilla to the King Kong of online services, with dominance of about half the market.

Seemingly overnight, the deal could add millions of CompuServe subscribers to AOL's rolls. At the same time, it is conveniently removing AOL's most difficult obstacle to growth: the limitations of its dial-up network.

The The selling of CompuServe online service has been plagued with access problems since it went to unlimited pricing in December. Although access has improved somewhat, the service can still become congested, which means users trying to log on are getting busy signals.

That's largely because AOL doesn't have enough dial-up modems to accommodate its burgeoning membership. But this deal will give it more modems, as well as turn the management of its networks over to larger operators.

This will mean fewer busy signals, according to a community update posted yesterday by AOL CEO Steve Case. Yesterday's announcements, he said, "will mean a significant increase in AOLnet modem capacity--which will mean fewer busy signals for you. We said we would make improving connectivity our top priority, and this deal is another example of us delivering on that promise."

But the deal also could pave a way for unwanted changes, analysts warn. "If antitrust laws don't block this deal, then maybe down the road you'll see AOL justifying more and more increases in price," speculated Youssef Squali, an analyst with Laidlaw and Company.

"We are looking at it," a Justice Department spokeswoman said today about the shakeup in online services.

It also could mean big changes for current CompuServe members. Under the terms of the deal, America Online gets the subscriber base of its No. 2 competitor and strengthens its foothold in Europe, one of the fastest-growing online markets.

Growing from 9 million to 11 or 12 million subscribers may not sound like a big jump, but the growth in sheer membership, combined with the addition of hardware, will give it the strength it needs to secure its position as dominator in the Internet access market.

"AOL Is becoming the de facto gorilla in the market with almost half the subscriber base," said Squali. For subscribers, that can mean just about anything.

Although AOL executives said they plan to keep CompuServe intact, analysts doubt it will stay that way. "Is AOL really going to keep CompuServe as a standalone service?" asked Mark Mooradian, an online analyst with Jupiter Research. "No. I find it hard to understand why you would own two online services that ostensibly compete against each other. That's not the trend AOL has followed in the past."

Others agreed, pointing to AOL's consistent strategy of creating a brand name so big advertisers won't afford to ignore it. For at least the past six months, the service has been working to garner more members so that advertisers will basically be forced to go to AOL in order to reach the maximum number of eyeballs. In addition, revenues from advertising and transactions will become even more important to its business now that AOL has decided to sell off ANS Communications, a moneymaker for the company.

The sticking point is AOL's focus on its core mission: building an online company that mirrors a content property such as a TV network. In trying to build a consumer network and a business network at the same time, AOL "has not been doing such a great job at either," said Kate Delhagen, an online industry analyst with Forrester Research. "AOL has suddenly hit the 10 million member goal for the year...Now they'll be able to focus on satisfying their customer base and becoming a real media company."

"AOL finally is moving out of the access business," Mooradian added. "Now they're even more dependent on advertising and commerce."

Ultimately, AOL will wind up acquiring close to 2 million members because of customer overlap and the departure of some CompuServe members before the deal is closed, Delhagen predicted.

Analysts say this move makes AOL an even more attractive place both for advertisers and merchants. "It's going to help America Online in the commerce and advertising market," said Karen Burka, a Cowles/Simba analyst. "They can jack up the advertising rates and offer marketers bigger numbers on sales."

But questions remain. Can AOL, which has been criticized for the reliability of its service, keep Compuserve's customers? Can it win the Justice Department's approval in closing a deal that combines the membership rosters of the two largest online services? AOL's answer to both is a definitive yes.

AOL Studios chief executive Ted Leonsis insisted that the company will continue to operate CompuServe as a separate entity. "CompuServe has focused on business customers and AOL on consumers. They complement each other nicely."

As for the antitrust concerns, he conceded that it could take months to win the necessary regulatory approvals to complete the deal. "Deals of this size can take up to six months to close."

Although AOL walks away from the deal with $250 million in cash ($175 million from WorldCom and an additional $75 million from its European partner, Bertelsmann) plus millions of CompuServe subscribers, Leonsis said pricing concessions from WorldCom in the five-year network services contract are worth $200 million in savings, money he said would flow to AOL's bottom line.

It was also unclear how the deal would be seen internationally.

For AOL's closest competitor, Microsoft Network, it means that it has a longer way to go should it want to catch AOL. But that didn't seem to worry at least one MSN executive.

Today's announcement "really isn't going to affect our strategy moving forward," said Jeff Sanderson, general manager of marketing. "[AOL] acquired these customers. They're going to maintain them separately. If they maintain them separately, the landscape to the customer feels very much as it does today."

But even if AOL decides eventually to absorb CompuServe members, that will not hinder MSN's ability to cultivate new members, as well as advertisers and commerce partners, according to Sanderson. "Mergers are hard. We'll know in a year how it turned out for them. For us, we're concentrating on making our network better."

For months, AOL's chief executive Steve Case has been stating that his goal was to boost the service's membership to 10 million by the end of the year. Last week, the company announced that it had surpassed 9 million members; the proposed deal with CompuServe, at least in theory, will bring the total to 11.6 million--well ahead of the 10 million mark.

But AOL won't stop there. Leonsis reiterated the company's ambitious goal of reaching 20 million subscribers in order to be considered a national advertising buy alongside other media properties, although he didn't offer a time frame.

America Online will have to work to keep its new CompuServe customers. Unlike cable television operators, for example, which hold monopolies in most markets, online customers are free to switch among many competitors.

CompuServe members could simply choose to walk and AOL will have to be especially sensitive to them if they want to keep those subscribers.

"CompuServe subscribers tend to be professionals or managers that for the most part are interested in the reliability of the access and the forums that CompuServe offers, neither of which have been hallmarks of what AOL has provided," said Mooradian.

Added Forrester's Delhagen: "I wouldn't be surprised if the conversion rate is less than 50 percent. AOL, if it's smart, will offer an incentive for people to convert."

Although most online subscribers live in the United States, the fastest growth in new subscribers is taking place in Europe, analysts say. CompuServe long had been a dominant force in that market. Many Europeans equated the Internet with CompuServe, just as they do with AOL in the United States.

"We think we have the opportunity to be the No. 1 international player," Leonsis added.

Senior writer Tim Clark contributed to this report.

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