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Q. Can you talk about your flat-rate pricing arrangement and how that's working? And do you foresee changing that at any time or raising the rate or going back to a rate based on usage?
A. I think it's working well, and we have no plans to change it. The difficulty we've had is more in the context of it working too well in the sense that the demand for it exceeded our expectations significantly. Therefore, in the January, February, March [of 1997] time frame, it was a crisis because of the quality problems. But that really related to existing customers using AOL more than we thought, and new customers, even with limited marketing, bought things at AOL more than we thought. The consumers clearly love it. There's no question about it.
Q. So [consumers] would be paying more than if they were paying by the hour?
A. Oh yeah. A year ago, before we went to that, I think our average bill was similar. If you ask, you have a $4.95 three-hour option as well as the unlimited option. We have a $9.95 bring-your-own-access option. If you already have an Internet connection in your office or cable system or something and don't need access from us, it's $9.95. There's a few different price quotes. Our average revenue is $17, $18 [per customer], which is about what it was a year ago. The average usage has gone from a year ago being about five, six hours to being 20 hours. So people obviously are getting a lot more. If you quote a price list, there's some other options, but basically, $9.95 for five hours use and $3 an hour for extra use. So what does that work out to be? $40, $55 to get the kind of service you're now getting for $20. So consumers love it.
The question in the early part of the year was, "Can we have the demand?" Then it shifted to, "Can you make money and is it sustainable?" I think we've demonstrated in the past couple of quarters that we can make money, and we are making money. And a lot of that is the growth we're seeing in advertising and commerce.
There's just no question in my mind that the advertising and commerce revenues are going to be huge. ... A few years ago, the concept of other revenue didn't even exist. It was zero. And in the last quarter, it was at the annualized rate of a quarter of a million dollars or so.
Q. You thought that your advertising revenues would be so significant and growing that you'll be able to continue to match or undercut the barebones ISP provider?
A. Yes. A year and a half ago, before we moved to flat pricing, the AOL Deathwatch [was underway]. The reason we're supposed to die is because the expectation that we'll die persists. The belief was that we have no chance. Because, first of all, this thing called the Internet. [AOL's] got some proprietary, closed system, and the Internet's open. The open always wins. So [AOL is] going to go like Macintosh.
Moreover, they have some cost structure we don't understand. We know they can't compete with the Internet guys. And the mistake was, I guess, just underestimating us to some degree because we always believed in the Internet. ... You can read articles in the Washington Post five years ago, four years ago the Internet was an opportunity, not a threat. And it turned out that way because the consumer interest in the Internet has fueled demand for AOL. And AOL has emerged as the dominant Internet provider for the consumer market.
And the reason is that we recognize it was not just about open versus closed technology. Nobody cares about HTML; nobody cares about JAVA; nobody cares about ActiveX; nobody cares about any of that. They care about what it's going to do for them. What we're delivering, and what we put together was a hybrid technology strategy that is superior to a standalone, Net-only technology strategy.
Particularly in light of the fact that the real world out there has pretty normal PCs with pretty normal memory, connected to pretty normal, usually slowish modems. And they want it to work in a reasonably satisfying way. So our set of technologies allow us to deliver a more engaging content to slower modems in a more satisfying way, while integrating fully your Netscape, Microsoft, whatever Internet technology. So it really is kind of the Internet and a whole lot more that's designed for a massive market. I think consumers have demonstrated that that's what they want.
On the pricing, cost side, there is never a cost advantage for a so-called barebones provider. There are some economies of scale in this business in terms of the acquisitions and the hardware and so forth. And so the question is really about, "How do you make money?" And our desire was to invest heavily in marketing to build the brand and heavily in content to extend the value of the proposition where they believe the advertising and commerce were going to pick up speed. And that's pretty much what's happened.
We focus more on a health club kind of pricing strategy where they basically sell a year or two in advance at a lower monthly fee. They talk about $10.95, but what they're really saying is, "Give us $300 up front," which is as much as an attempt to raise venture capital from customers as it is anything else. Which is fine. In fact, I think it's a very clever strategy, but it was never really the monthly fee that was advertised. So we have a price that is viewed as at parity with the market. It may be a little bit less or a little bit more.
Basically, the pricing is a non-issue in the customer decision process. And the question becomes, "What do I get for my twenty bucks a month?" Another three million customers this year decided that they'd go with AOL instead of the alternative, of which there are many, because they would get that Internet access plus a whole lot more. Some of them may value the content we have or the context that makes it easier or the community or whatever.
Q. What is your churn at the ten million customer level?
A. We don't release churn. We do release the marketing costs each quarter and we do release the net averages each quarter. And it will probably be the easiest metric to watch, and we've seen the marketing costs as a percentage of revenue go down substantially over the past year.
Q. Do you remember what you told us two years ago? You gave us some indication, which was quite astounding, I remember. Anybody remember this?
A. I remember what it was, but I'm not going to tell you.
Q. I just now keep getting [disks] in the mail all the time, so I wonder why. I have ... 23 floppies and 2 CDs from AOL.
A. Well, don't you have any friends you can give them to?
Q. It just doesn't makes sense that you keep sending me this stuff.
A. Well, it does make sense. Maybe we're stupid, but it does make sense. There are probably better ways to distribute software in the long run. For example, in the last few years, we've been successful in getting AOL built into just about every computer built into Windows 95, built into Macintosh, as well as partner with everybody. So the need to mail out disks has diminished somewhat. But we do track you through these programs. And if we're mailing a diskette, we're saying, "Well, we're using this list, and sending this diskette. What percentage of people would mail disks if you end up using the software? Of those, how many end up being customers for how long?" And the economics of it works terrifically well. So there is a method to the madness.
It gets proven if you look at the marketing costs a year ago. I think it was 35 percent of revenue, something like that. And last quarter it was 17 or 18 percent of revenue.
Q. Has the churn rate itself gone down?
A. Well, we think of it as a retention rate. We're much more positive. And it is going up.
Q. I didn't understand from your answer about the economics. In the one pricing strategy, whether you're gaining more customers, your margins are shrinking. [So you say that] your growth is really coming from advertising and other ancillary revenues, rather than the actual signing of customers.
A. We lose money on signing up the customers, where there's some marketing costs associated with giving them a free month. We have 5,000 people in customer service; we have to get them up to speed. So there's an upfront cost to get somebody on, which is why looking at the cash spent on marketing as a percentage of total revenue is sort of the easiest method to look at. But there's no question that ... advertising and commerce will grow and will be the main profit center. But now we make a little bit of money on the service itself. But I wouldn't be surprised [if] in the long run we've lost a little bit of money. It doesn't much matter whether you make a little bit or lose a little bit as you well know, because you lose a ton on every copy [of The Washington Post]. Generally speaking, the newspapers get 80 percent of revenue from advertising and, therefore, obviously are selling the product at well, well, well below cost. I'm now just selling slightly above cost, which is pretty good.
Q. [So you want to be like a newspaper]?
A. I'm not sure we have to be at that model. But I think there's opportunity on the advertising commerce side that should enable us to continue to maintain an affordable price for the masses that is competitive with alternatives. And then you expand the audience and continue to invest in innovation, whether it be the top software you use to do things or gauging content or [doing] platforms, [getting] some replay devices or broad band technology or international expansion or education lots of things that we think are interesting while still meeting the profit targets we've set on Wall Street.
Q. The average subscriber maintains this relationship with you for about a year or so.
A. No. Nice try to get me to give you the right number. I hear a number, but it's not that. (laughter)
Q. What was it?
A. I'm not going to tell you. (laughter)
Q. We have this on tape somewhere else. Is that number growing?
A. I said that number was growing. We're ten times improving.
Q. Commerce is going to be so vitally important for you as you continue to evolve. On one hand, you guys are the primary service for these new people that are just getting online, not the guys who download Netscape at 6:15 in the morning in Silicon Valley. At the same time, it's those people leaving you veteran users who are now feeling more and more comfortable with putting their credit card number out online, buying things. And so, the constituency you have is not the most ideal constituency to start in getting them to engage in online commerce. What's your strategy to proselytize these people to get them to start using you guys as an online shopping mall to help build up that advertising and commerce and other revenue line in your financial?
A. I agree with part of your comments. I think there are differences between the sophisticated side of the market that revels in technology and the mass market that doesn't. But I'm not sure it follows [that there's] any effect on commerce revenue. Indeed, I think we're doing a better job generating commerce revenues from our audience than I think anybody else is from their audience. And some of it is security related, because of the fact that AOL has technology to do anything you want. But in the AOL world, it is somewhat more protected. ... Our server is safer than if it's anybody's client, connected to anybody's server, anywhere in the world. People take a little bit of comfort in that.
I think they also are by and large learning to trust AOL. Now a lot of this is about building confidence, and we've done things in the past year that have nothing to do with technology. We've done technology things too, but we've done things that have nothing to do with technology that I think have a much more significant impact on this issue.
For example, we came up with an AOL guarantee program an AOL certified merchant program. It basically says, "You buy stuff on AOL, we stand 100 percent behind all the merchants. No matter what happens, we'll cover you on it." Those kind of programs I think are very comforting to people. Anybody can focus on security technology as the gating item to commerce. I think that is a small piece of the puzzle, and it's really about consumer confidence.
Just as we see in the world of credit cards today. Credit cards are not particularly safe. They're less secure than a lot of the Web technologies, for example, but people have learned to trust them, because there's policy that's been built [into the business] such things as you lose your credit card, you call. The worst you can have is a fifty dollar charge, that kind of thing. It has nothing to do with technology, which is really imperfect, because everybody's heard the stories about somebody handing their credit card to somebody in a restaurant. And they come back five minutes later, and you have no idea what they've done to their credit card. So clearly, it's a very insecure technology that has been broadly adopted to consumers who've learned to trust it and has more to do with business practice. So we've actually done a very good job on the commerce side. Others in this business are looking at us and trying to mimic what some of those things we're doing in the commerce area as a result of that.
Q. How would you place the Washington region as the center of technology nationally? What do you think of these efforts that are around to try to feed that idea that this is a national technology center, tracking venture capital and helping entrepreneurs associations?
A. I think it's come a long way in ten years. ... You know, mostly out of luck, which is the way Silicon Valley happened and Route 128 and so forth. It has become a communications hub and, to a meaningful extent, an Internet hub. I think that's important. And a lot of it, I think, had to do with the fact that early on, some of the things that we spun out were coming out of government contractors. Many of them are located here.
Or early on, some communications companies, MCI being an example, basically decided that [because their businesses were heavily involved in] public policy kind of issues decided to center here. But for whatever reason, companies like AOL and UUNet and others were started here and have been growing here and it's becoming more and more a hub. It's not quite, say, like a Silicon Valley, but I think it's got more credibility.
When we started ten years ago, there was zero infrastructure, zero venture capital. But there was just not the same kind of entrepreneurial culture that existed in that area. Which isn't all bad. It made it a little harder to get started I think, but also probably made it easier to expand rapidly because we became, and I think to some extent still are, the interesting company in Washington, the fun one to work [for]. The one that has opportunity to make money on stock option. If you had that entrepreneurial bent, and particularly because it's new medium, Internet, so forth, AOL was sort of a magnet for a lot of those people. And we did not have and still do not have the kind of intense competition for people that they have in Silicon Valley as a result.
It helps that the atmosphere's a little different so our average tenure is much, much higher than for companies in Silicon Valley.
Q. Your peers say you haven't been personally involved in this effort among the Virginia leaders to strengthen the local technology community. Do you agree with that, and why?
A. I guess I partially agree with that. I would say that in terms of directly involved with the local efforts, we probably support them more than is visible. I think that the greatest contribution we've made is the fact that we have become one of the magnet companies of the area. We are sort of the shining star people point to. We have hired thousands of people in the last few years. Five years ago we had 200 employees and now we have 8,000 employees. They're not all here; they're all around the country. But nothing could help the Washington, D.C., Northern Virginia, however you want to define it, technology momentum more than a company coming out of nowhere and being a major global force in the market and being centered in Washington. So the efforts we've focused on, which is just trying to build the company, build the medium, I think directly helped the region.
Q. When you moved your operations to Dulles, has anybody talked of moving out of the region at all?
A. In terms of the decision to move to Dulles, there was never a discussion to be anywhere else. The big debate was whether we move at all. Actually, [early on I advocated] just staying there and kind of liked the fact that we started there. We just expanded building in Tyson's Corner are around there. And just the notion of moving out to someplace farther away, discussing people's commute, and changing in some subtle way the cultures of the rule. It was disconcerting to me, but I think it marks us as a creature of habit that I've been in the same place for ten years and just kind of got used to it. But change is OK ... and there is no way to have anything close to a corporate campus environment at Tyson's Corner. We would end up taking over all the buildings in the vicinity, and there would be no sense of connection, community, what have you. So we had to basically find a place where we had some space to grow.
And it was not just buying an existing facility which had a lot of space, but also the eighty acres around it that gave us the ability to essentially build the campus. So there were other places that we looked at in the Northern Virginia area, but there was never consideration of anywhere else.
Q. Do you feel a little isolated, being that far out, beyond the Dulles Toll Road? You're 25 minutes away from Tyson's.
A. Not really. Our world is a global world. Phone calls and e-mails, people come visit us.
Q. Do you award your employees with options? Is that a big part of their compensation?
Q. How many millionaires?
A. We have a bunch.
Q. What do you see in the future for your local online businesses to individual cities? Have you replicated that around the country?
A.Yes. We're in over a dozen cities in a major way with local staffs and in a couple dozen cities in a more modest way. We're doing listings and things. No, I think it's very important. This notion of a connected society and changing how people get information and communicate, whatever. A lot of what happens you will know at local levels, so it's inconceivable that we wouldn't have a local strategy.
Our view, kind of like the communications question, is partnerships are good where appropriate. We've established the business city and partnership with Tribune. We're talking to others on and off. We've talked to the Post for probably about five years. There's no particular reason we couldn't work together, but one way or another, we're going to have a local presence.
Interview continued, Part III