Description
America Online Case Analysis
AMERICA ONLINE
Question 1: Prior to 1995, why was America Online (AOL) so successful in the commercial online industry relative to its competitors CompuServe and Prodigy?
America Online Inc. was the pioneer in the field of providing online services offering a wide plethora of services to its subscribers which included the Internet, multimedia, email, online conferences, entertainment, software, computing support, interactive magazines and newspapers, and online classes, as well as other emerging technologies. The company also provided data network services, new media and interactive marketing services and CD-ROM production services.
Sources of Revenue: The main sources of revenue for the company was through membership fees, as well as from content providers and merchandisers through advertisements and commissions on merchandised sales and it catered to over 4 million subscribers. Its main competitors in this field CompuServe and Prodigy were also successful in their own way but made AOL stand apart was the following strategic decisions:
1. Simplistic rate structure:
AOL’s rate structure was the easiest for the customers to understand, in comparison to its competitors. Since CompuServe and Prodigy charged extra for premium services and downloading, customers found it simpler to deal with AOL.
2. Increasing the subscriber base and retaining them :
Attracting new subscribers was top priority for AOL and they did this using several innovative methods:
2.1 Retention programs: AOL invested in specialized retention programs including regularly scheduled online events and conferences, online promotion of upcoming events and new features and the addition of new content, services and software programs. 2.2 Investment in the growth of existing businesses: AOL invested in expanding its existing businesses and leveraged its technology, management skills, and content packaging skills to exploit new business opportunities and enter new international markets. 2.3 Establishing loyalty labs: A new program introduced by the Company was the establishment of "loyalty labs” to test new and innovative approaches to increase member satisfaction and encourage members to stay with AOL. 2.4 Interactive Services and Wide range of products: AOL provided its customers with full range of interactive services and a wider range of products in comparison to its competitors.
3. Creating unique content on the web:
In order to create unique content, AOL participated in a number of joint ventures. It was important to AOL that it showcased the newest stars of cyberspace and special interest sites created by popular entrepreneurs. AOL paid the entrepreneurs 20% of the revenue but in return demanded exclusive contracts with the entrepreneurs demanding them. Thus the content available on AOL was not available anywhere else. This was what attracted customers to AOL and kept them loyal to it.
4. Agreements
and
Alliances
for
promotion
of
company’s
services: AOL ventured into various direct marketing and Co-Marketing efforts to attract and retain customers. The co-marketing companies bundled the AOL software with their computer products, facilitating easy trial use by the customers. Accompanying each program disk was a unique registration number and password that could be used to generate a new AOL Account. Customers could pay using their credit card. In addition the customers were given 10 hours of free use. All the above factors became a source of customer delight thus increasing AOL’s subscriber base and giving it a distinct edge vis-à-vis its competitors.
Question 2: As of 1995, what are the key changes taking place in the commercial online industry? How are they likely to affect AOL’s future prospects? The online consumer industry in 1995: ? Was expected to grow by 30% to $1.4 billion from $1.1. billion in 2004. ? Industry leaders AOL, CompuServe and Prodigy served about 8.5million of the existing subscribers. Key changes taking place in the commercial online industry since 1995 were as follows: 1. The advent of Internet World Wide Web 2. The entrance of Microsoft Network acting as bookstore rather than a publisher. 3. They provided the content providers with alternative distribution channels enabling them to exercise greater control over their products and earn potentially higher revenues. 4. The oligopoly in the industry was expected to fade fast. Affect on future Prospects of AOL: 1. The increase in competition required additional pricing programs and increased spending on marketing, content procurement and product development. This limited AOL’s opportunities to enter into and/or renew agreements with content providers and distribution partners and also limited its scope to grow its subscriber base. 2. The proprietary services and contents were moving to the Web sites. The Web will enable everybody with a computer to be his own publisher. The publisher having difficulty in collecting fees from the browsers reading their pages, could now do so with banks and Microsoft and other intermediaries working on to provide on – line currency. 3. The alternative of getting higher revenues and greater control over the format and font, the publishers will be allured to move to the Web and Microsoft and hence AOL’s business will just shrink. 4. These have resulted in increased attrition in the Company's subscriber base, hence loss of market online market share. 5. The company will have to cut its prices to retain its customers. 6. The competitive environment required additional pricing programs and increased spending on marketing, content procurement and product development. As the acquisition expenses escalated, the company had to invest heavily in other tie ups and acquisitions which meant that there was need for more capital funding and also additional working capital requirement.
7. As a result of all this, the margins that the companies had were to shrink, and this will have a huge deferred customer acquisition costs balance in its books. Question 3: Was AOL’s policy to capitalize subscriber acquisition costs justified prior to 1995? AOL’s biggest customers”. expenditure was the “cost of attracting new
AOL aggressively marketed its online service using both independent marketing efforts, as well as co-marketing efforts with computer magazine publishers & personal computer hardware & software producers. The promotions programs were personalized, like separate registration numbers and passwords were issued to that could be used to generate a new AOL account. They cost more than $40 per new subscriber in 1994. AOL’s main goal was to maximize customer subscription life. These costs were expended once to get a customer in loop post which other specialized retention programs were held. Going by that logic, a one time cost from which revenue/value can be generated in the coming years, these costs were capitalized as per accounting principles of matching costs with revenue.
1. CompuServe, AOL’s competitor, on the other hand, did not capitalize
these subscriber acquisitions costs. As per accounting principles, such a treatment for marketing expenditures was allowed. But there always arises a clash in two accounting principles: that of matching and conservatism. What AOL is following is matching principle, whereas the available option is conservatism, where the company should write off the expense in the year in which it is incurred and not carry it forward. CompuServe follows conservatism rather than matching principle. This would have given AOL an unfair advantage when it was compared with its peers.
2. Earlier, AOL amortization period for subscriber acquisition costs
was about 15 months. It was extended to 24 months from July 1, 1995. The company justified this aggressive accounting practice by declaring that the bundling & direct mail marketing had shown a longer response time. AOL claimed that the average life of an account had risen from 25 months in 1992 to 41 months. However, all its new customers were added (from 1992 till date June 1995) in these 36
months. But considering the uncertainties surrounding the online business given that customers had numerous other options, 41-month average was a mere projection. Moreover this was quite inappropriate as competitors were emerging very fast in this industry. This change in policy had decreased the company’s reported loss by $1.95 million in the three months ended September 30, 1995. The management probably wanted to improve their earnings position so that the share price of AOL shares would shoot up in the market and hence adopted this aggressive accounting approach. So this policy of AOL to capitalize its customer subscription cost is not justified. Question 4: Given the changes discussed in question 2, do you think AOL should change its accounting policy as of 1995? Is the company’s response consistent with your view? The accounting laws require that the capitalization and amortization of direct response advertising costs should be done only when persuasive historical evidence exists which allows an entity to reliably predict the future net revenues that will be obtained as a result of that advertising. This condition to capitalize the expenses doesn’t get satisfied in the AOL's case since there is no certainty about: 1. The future retention or attrition rates of subscribers obtained through its capitalized advertising costs; 2. The revenues those subscribers would generate to AOL; and 3. The costs AOL would incur to obtain those revenues. AOL was operating in a nascent business sector characterized by rapid technological change: 1. AOL's business model was evolving; 2. Extraordinarily rapid growth in AOL's customer base caused significant changes to its customer demographics; 3. AOL's customer retention rates were unpredictable; 4. AOL's product pricing was subject to potential change; 5. AOL could not reliably predict future costs of obtaining revenues; 6. AOL's competition was increasing; and 7. AOL was experiencing negative cash flow Hence it can be concluded that the company’s accounting practices are not consistent. The following should be noted:
1. Customer Acquisition Costs, which it recently changed to 24 months, giving up on the 12- 18 month followed earlier, on amortization of such expenses, and product development cost, should be changed as with so much competition, AOL cannot anticipate the customers’ retention for so long. AOL should probably shift from matching principle to conservative principle of accounting, and expense the customer acquisitions costs as and when they are incurred. 2. The company should also reduce the goodwill amortization period. 3. Also a price war can be expected due to increasing competition. Hence, future revenues per customer should be pessimistically forecasted and again, an allowance for lesser number of subscribers and higher rate of attrition of the already subscribed customer should be there. Question 5: What would be the effect on AOL’s 1995 balance sheet of all the capitalized subscriber acquisition costs were written off? If AOL expensed all the subscriber acquisition costs incurred in fiscal 1995 during the same year, what would be the effect on its income statement? Please see attached Excel Sheet for workings
Question 6: Compute AOL’s market to book ratio as of November 8, 1995. The company raised $100 million by selling new shares on October 10, 1995. The market price of the shares was $58.37. So the number of new shares issued in October is 1.713 million. • Number of shares in June = 33.986 million • Book Value = $ 217.944 million • Total Book value in November = $ 317.944 million (= 217.944+100) • Total number of shares = 35.699 million (=33.986+1.713)
Hence, • BV per share = $ 8.906 • MV per share= $ 81.63 (given) Market to Book Ratio = (MV per share / BV per share) = 9.165
Question 7: Assuming a perpetual average growth rate in book value of 15% per year, calculate the long-run average return on equity needed to be earned by AOL to justify its market to book ratio as of November 8, 1995. We have the following relations: Book Value per share = shareholder's fund / No. of shares Return on equity = PAT / Shareholder's fund Given that the perpetual growth rate is 15% which means ROE should also be 15% to justify its market to book ratio as of November 8, 1995.
Question 8: Based on your analysis in questions 1-5, do you think the return on equity and growth rates assumptions implied by AOL’s market to book ratio realistic? The following three observations about the company’s accounting policies give us an indication that AOL’s ROE and growth rate assumptions implied by its market to book ratios weren’t realistic: ? Given the quick changing scenario in the technology sector, AOL amortized its software development costs over five years which was quite an unrealistic assumption. Also, AOL amortized its customer acquisition and amortization expenses which wasn’t the case with its competitors. AOL capitalized its product development costs, direct labor and related overhead for software produced by the company and the costs of software purchased from third parties. This enabled the company to show higher reported
?
?
profits than its competitors. Hence, they were able to show higher ROE.
doc_555759882.doc
America Online Case Analysis
AMERICA ONLINE
Question 1: Prior to 1995, why was America Online (AOL) so successful in the commercial online industry relative to its competitors CompuServe and Prodigy?
America Online Inc. was the pioneer in the field of providing online services offering a wide plethora of services to its subscribers which included the Internet, multimedia, email, online conferences, entertainment, software, computing support, interactive magazines and newspapers, and online classes, as well as other emerging technologies. The company also provided data network services, new media and interactive marketing services and CD-ROM production services.
Sources of Revenue: The main sources of revenue for the company was through membership fees, as well as from content providers and merchandisers through advertisements and commissions on merchandised sales and it catered to over 4 million subscribers. Its main competitors in this field CompuServe and Prodigy were also successful in their own way but made AOL stand apart was the following strategic decisions:
1. Simplistic rate structure:
AOL’s rate structure was the easiest for the customers to understand, in comparison to its competitors. Since CompuServe and Prodigy charged extra for premium services and downloading, customers found it simpler to deal with AOL.
2. Increasing the subscriber base and retaining them :
Attracting new subscribers was top priority for AOL and they did this using several innovative methods:
2.1 Retention programs: AOL invested in specialized retention programs including regularly scheduled online events and conferences, online promotion of upcoming events and new features and the addition of new content, services and software programs. 2.2 Investment in the growth of existing businesses: AOL invested in expanding its existing businesses and leveraged its technology, management skills, and content packaging skills to exploit new business opportunities and enter new international markets. 2.3 Establishing loyalty labs: A new program introduced by the Company was the establishment of "loyalty labs” to test new and innovative approaches to increase member satisfaction and encourage members to stay with AOL. 2.4 Interactive Services and Wide range of products: AOL provided its customers with full range of interactive services and a wider range of products in comparison to its competitors.
3. Creating unique content on the web:
In order to create unique content, AOL participated in a number of joint ventures. It was important to AOL that it showcased the newest stars of cyberspace and special interest sites created by popular entrepreneurs. AOL paid the entrepreneurs 20% of the revenue but in return demanded exclusive contracts with the entrepreneurs demanding them. Thus the content available on AOL was not available anywhere else. This was what attracted customers to AOL and kept them loyal to it.
4. Agreements
and
Alliances
for
promotion
of
company’s
services: AOL ventured into various direct marketing and Co-Marketing efforts to attract and retain customers. The co-marketing companies bundled the AOL software with their computer products, facilitating easy trial use by the customers. Accompanying each program disk was a unique registration number and password that could be used to generate a new AOL Account. Customers could pay using their credit card. In addition the customers were given 10 hours of free use. All the above factors became a source of customer delight thus increasing AOL’s subscriber base and giving it a distinct edge vis-à-vis its competitors.
Question 2: As of 1995, what are the key changes taking place in the commercial online industry? How are they likely to affect AOL’s future prospects? The online consumer industry in 1995: ? Was expected to grow by 30% to $1.4 billion from $1.1. billion in 2004. ? Industry leaders AOL, CompuServe and Prodigy served about 8.5million of the existing subscribers. Key changes taking place in the commercial online industry since 1995 were as follows: 1. The advent of Internet World Wide Web 2. The entrance of Microsoft Network acting as bookstore rather than a publisher. 3. They provided the content providers with alternative distribution channels enabling them to exercise greater control over their products and earn potentially higher revenues. 4. The oligopoly in the industry was expected to fade fast. Affect on future Prospects of AOL: 1. The increase in competition required additional pricing programs and increased spending on marketing, content procurement and product development. This limited AOL’s opportunities to enter into and/or renew agreements with content providers and distribution partners and also limited its scope to grow its subscriber base. 2. The proprietary services and contents were moving to the Web sites. The Web will enable everybody with a computer to be his own publisher. The publisher having difficulty in collecting fees from the browsers reading their pages, could now do so with banks and Microsoft and other intermediaries working on to provide on – line currency. 3. The alternative of getting higher revenues and greater control over the format and font, the publishers will be allured to move to the Web and Microsoft and hence AOL’s business will just shrink. 4. These have resulted in increased attrition in the Company's subscriber base, hence loss of market online market share. 5. The company will have to cut its prices to retain its customers. 6. The competitive environment required additional pricing programs and increased spending on marketing, content procurement and product development. As the acquisition expenses escalated, the company had to invest heavily in other tie ups and acquisitions which meant that there was need for more capital funding and also additional working capital requirement.
7. As a result of all this, the margins that the companies had were to shrink, and this will have a huge deferred customer acquisition costs balance in its books. Question 3: Was AOL’s policy to capitalize subscriber acquisition costs justified prior to 1995? AOL’s biggest customers”. expenditure was the “cost of attracting new
AOL aggressively marketed its online service using both independent marketing efforts, as well as co-marketing efforts with computer magazine publishers & personal computer hardware & software producers. The promotions programs were personalized, like separate registration numbers and passwords were issued to that could be used to generate a new AOL account. They cost more than $40 per new subscriber in 1994. AOL’s main goal was to maximize customer subscription life. These costs were expended once to get a customer in loop post which other specialized retention programs were held. Going by that logic, a one time cost from which revenue/value can be generated in the coming years, these costs were capitalized as per accounting principles of matching costs with revenue.
1. CompuServe, AOL’s competitor, on the other hand, did not capitalize
these subscriber acquisitions costs. As per accounting principles, such a treatment for marketing expenditures was allowed. But there always arises a clash in two accounting principles: that of matching and conservatism. What AOL is following is matching principle, whereas the available option is conservatism, where the company should write off the expense in the year in which it is incurred and not carry it forward. CompuServe follows conservatism rather than matching principle. This would have given AOL an unfair advantage when it was compared with its peers.
2. Earlier, AOL amortization period for subscriber acquisition costs
was about 15 months. It was extended to 24 months from July 1, 1995. The company justified this aggressive accounting practice by declaring that the bundling & direct mail marketing had shown a longer response time. AOL claimed that the average life of an account had risen from 25 months in 1992 to 41 months. However, all its new customers were added (from 1992 till date June 1995) in these 36
months. But considering the uncertainties surrounding the online business given that customers had numerous other options, 41-month average was a mere projection. Moreover this was quite inappropriate as competitors were emerging very fast in this industry. This change in policy had decreased the company’s reported loss by $1.95 million in the three months ended September 30, 1995. The management probably wanted to improve their earnings position so that the share price of AOL shares would shoot up in the market and hence adopted this aggressive accounting approach. So this policy of AOL to capitalize its customer subscription cost is not justified. Question 4: Given the changes discussed in question 2, do you think AOL should change its accounting policy as of 1995? Is the company’s response consistent with your view? The accounting laws require that the capitalization and amortization of direct response advertising costs should be done only when persuasive historical evidence exists which allows an entity to reliably predict the future net revenues that will be obtained as a result of that advertising. This condition to capitalize the expenses doesn’t get satisfied in the AOL's case since there is no certainty about: 1. The future retention or attrition rates of subscribers obtained through its capitalized advertising costs; 2. The revenues those subscribers would generate to AOL; and 3. The costs AOL would incur to obtain those revenues. AOL was operating in a nascent business sector characterized by rapid technological change: 1. AOL's business model was evolving; 2. Extraordinarily rapid growth in AOL's customer base caused significant changes to its customer demographics; 3. AOL's customer retention rates were unpredictable; 4. AOL's product pricing was subject to potential change; 5. AOL could not reliably predict future costs of obtaining revenues; 6. AOL's competition was increasing; and 7. AOL was experiencing negative cash flow Hence it can be concluded that the company’s accounting practices are not consistent. The following should be noted:
1. Customer Acquisition Costs, which it recently changed to 24 months, giving up on the 12- 18 month followed earlier, on amortization of such expenses, and product development cost, should be changed as with so much competition, AOL cannot anticipate the customers’ retention for so long. AOL should probably shift from matching principle to conservative principle of accounting, and expense the customer acquisitions costs as and when they are incurred. 2. The company should also reduce the goodwill amortization period. 3. Also a price war can be expected due to increasing competition. Hence, future revenues per customer should be pessimistically forecasted and again, an allowance for lesser number of subscribers and higher rate of attrition of the already subscribed customer should be there. Question 5: What would be the effect on AOL’s 1995 balance sheet of all the capitalized subscriber acquisition costs were written off? If AOL expensed all the subscriber acquisition costs incurred in fiscal 1995 during the same year, what would be the effect on its income statement? Please see attached Excel Sheet for workings
Question 6: Compute AOL’s market to book ratio as of November 8, 1995. The company raised $100 million by selling new shares on October 10, 1995. The market price of the shares was $58.37. So the number of new shares issued in October is 1.713 million. • Number of shares in June = 33.986 million • Book Value = $ 217.944 million • Total Book value in November = $ 317.944 million (= 217.944+100) • Total number of shares = 35.699 million (=33.986+1.713)
Hence, • BV per share = $ 8.906 • MV per share= $ 81.63 (given) Market to Book Ratio = (MV per share / BV per share) = 9.165
Question 7: Assuming a perpetual average growth rate in book value of 15% per year, calculate the long-run average return on equity needed to be earned by AOL to justify its market to book ratio as of November 8, 1995. We have the following relations: Book Value per share = shareholder's fund / No. of shares Return on equity = PAT / Shareholder's fund Given that the perpetual growth rate is 15% which means ROE should also be 15% to justify its market to book ratio as of November 8, 1995.
Question 8: Based on your analysis in questions 1-5, do you think the return on equity and growth rates assumptions implied by AOL’s market to book ratio realistic? The following three observations about the company’s accounting policies give us an indication that AOL’s ROE and growth rate assumptions implied by its market to book ratios weren’t realistic: ? Given the quick changing scenario in the technology sector, AOL amortized its software development costs over five years which was quite an unrealistic assumption. Also, AOL amortized its customer acquisition and amortization expenses which wasn’t the case with its competitors. AOL capitalized its product development costs, direct labor and related overhead for software produced by the company and the costs of software purchased from third parties. This enabled the company to show higher reported
?
?
profits than its competitors. Hence, they were able to show higher ROE.
doc_555759882.doc