FORM 10-Q
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
(Mark One)
[X] Quarterly Report under Section 13 or 15(d) of the Securities Exchange Act
of 1934
For the quarterly period ended: December 31, 1996
OR
[ ] Transition report pursuant to section 13 or 15(d) of the Securities
Exchange Act of 1934
For the transition period from to
Commission File Number:
0-19836
America Online, Inc.
(Exact name of registrant as specified in its charter)
Delaware 54-1322110
(State or other jurisdiction of (I.R.S. Employer Identification No.)
incorporation or organization)
22000 AOL Way, Dulles, Virginia 20166-9323
(Address of principal executive offices and zip code)
Registrant's telephone number, including area code: (703) 448-8700
Former name, former address, and former year, if changed since last report: Not
applicable
Indicate by check mark whether the registrant (1) has filed all reports required
to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during
the preceding 12 months (or for such shorter period that the registrant was
required to file such reports), and (2) has been subject to such filing
requirements for the past 90 days.
Yes X No
Indicate the number of shares outstanding of each of the Issuer's classes of
Common Stock, as of the latest practicable date.
Title of each class
Common stock $.01 par value
Shares outstanding on January 31, 1997........................95,858,039
AMERICA ONLINE, INC.
INDEX
Page
PART I. FINANCIAL INFORMATION
Item 1. Consolidated Financial Statements
Consolidated Balance Sheets-December 31, 1996
and June 30, 1996 3
Consolidated Statements of Operations-Three
months ended December 31, 1996 and 1995 4
Consolidated Statements of Operations-Six
months ended December 31, 1996 and 1995 5
Consolidated Statements of Cash Flows-Six
months ended December 31, 1996 and 1995 6
Notes to Consolidated Financial Statements 7
Item 2. Management's Discussion and Analysis of
Financial Condition and Results of Operations 10
PART II. OTHER INFORMATION
Item 6. Exhibits and Reports on Form 8-K 22
Signatures 23
<TABLE>
AMERICA ONLINE, INC. AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEETS
(Amounts in thousands, except share data)
December 31, June 30,
1996 1996
ASSETS (Unaudited)
<S> <C> <C>
Current assets:
Cash and cash equivalents $130,189 $118,421
Short-term investments - 10,712
Trade accounts receivable 52,147 49,342
Other receivables 23,740 23,271
Prepaid expenses and other current assets 91,195 68,832
Total current assets 297,271 270,578
Property and equipment at cost, net 112,216 101,277
Other assets:
Product development costs, net 61,761 44,330
Deferred subscriber acquisition costs, net - 314,181
License rights, net 6,237 4,947
Other assets 45,244 35,878
Deferred income taxes 20,702 135,872
Goodwill, net 42,309 51,691
$585,740 $958,754
LIABILITIES AND STOCKHOLDERS' EQUITY
Current liabilities:
Trade accounts payable $133,860 $105,904
Accrued personnel costs 10,788 15,719
Other accrued expenses and liabilities 253,749 127,898
Deferred revenue 89,606 37,950
Current portion of long-term debt and
capital lease obligations 2,249 2,435
Total current liabilities 490,252 289,906
Long-term liabilities:
Notes payable 18,794 19,306
Deferred income taxes 20,702 135,872
Deferred revenue 5,816 -
Minority Interests 10,108 -
Other liabilities 1,274 1,168
Total liabilities 546,946 446,252
Stockholders' equity:
Preferred stock, $.01 par value; 5,000,000
shares authorized, 1,000 shares issues
and outstanding at December 31, 1996
and June 30, 1996 1 1
Common stock, $.01 par value, 300,000,000
shares authorized, 95,042,766 and
92,626,000 shares issued and outstanding
at December 31,1996 and June 30, 1996,
respectively 950 926
Additional paid-in capital 554,104 519,342
Accumulated deficit (516,261) (7,767)
Total stockholders' equity 38,794 512,502
$585,740 $958,754
See accompanying notes.
</TABLE>
<TABLE>
AMERICA ONLINE, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF OPERATIONS
(Amounts in thousands, except per share data)
Three months
ended
December 31,
1996 1995
(Unaudited)
<S> <C> <C>
Revenues:
Online service revenues $351,220 $224,525
Other revenues 58,192 24,620
Total revenues 409,412 249,145
Costs and expenses:
Cost of revenues 245,374 145,928
Marketing 146,777 52,158
Product development 21,673 10,330
General and administrative 48,810 23,986
Amortization of goodwill 1,589 1,749
Restructuring charge 74,327 -
Total costs and expenses 538,550 234,151
Income (loss) from operations (129,138) 14,994
Other income (expense) (1,367) 1,460
Settlement charge (24,300) -
Income (loss) before provision for
income taxes (154,805) 16,454
Provision for income taxes - (6,924)
Net income (loss) $ (154,805) $9,530
Earnings (loss) per share: $ (1.64) $0.09
Weighted average shares outstanding 94,284 107,177
See accompanying notes.
</TABLE>
<TABLE>
AMERICA ONLINE, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF OPERATIONS
(Amounts in thousands, except per share data)
Six months
ended
December 31,
1996 1995
(Unaudited)
<S> <C> <C>
Revenues:
Online service revenues $662,352 $403,004
Other revenues 97,042 44,043
Total revenues 759,394 447,047
Costs and expenses:
Cost of revenues 433,597 265,005
Marketing 222,649 89,082
Product development 40,999 19,910
General and administrative 84,374 44,466
Write-off of deferred subscriber
acquisition costs 385,221 -
Acquired research and development - 16,981
Amortization of goodwill 3,509 3,412
Restructuring charge 74,327 -
Total costs and expenses 1,244,676 438,856
Income (loss) from operations (485,282) 8,191
Other income 1,088 2,292
Settlement charge (24,300) -
Income (loss) before provision for
income taxes (508,494) 10,483
Provision for income taxes - (11,860)
Net loss $ (508,494) $ (1,377)
Loss per share: $ (5.43) $ (0.02)
Weighted average shares outstanding 93,727 81,048
See accompanying notes.
</TABLE>
<TABLE>
AMERICA ONLINE, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASH FLOWS
(Amounts in thousands)
Six months
ended
December 31,
1996 1995
(Unaudited)
<S> <C> <C>
Cash flows from operating activities:
Net loss $(508,494) $(1,377)
Adjustments to reconcile net loss to net
cash provided by (used in) operating activities:
Write-off of deferred subscriber
acquisition costs 385,221 -
Non-cash restructuring charges 19,937 -
Depreciation and amortization 27,336 13,410
Amortization of subscriber acquisition costs 59,189 41,144
Loss on sale of property and equipment - 44
Charge for acquired research and development - 16,981
Changes in assets and liabilities:
Trade accounts receivable (3,258) (4,460)
Other receivables 4,435 (15,064)
Prepaid expenses and other current assets (22,043) (9,207)
Deferred subscriber acquisition costs (130,229) (153,317)
Other assets (10,181) (8,865)
Trade accounts payable 27,211 28,194
Accrued personnel costs (6,241) 3,297
Other accrued expenses and liabilities 118,717 14,284
Deferred revenue 51,656 6,749
Deferred income taxes - 11,860
Other liabilities 5,561 169
Total adjustments 527,311 (54,781)
Net cash provided by (used in) operating activities 18,817 (56,158)
Cash flows from investing activities:
Short-term investments 10,712 9,497
Purchase of property and equipment (21,194) (18,578)
Product development costs (31,976) (14,291)
Purchase costs of acquired businesses (475) (4,159)
Net cash used in investing activities (42,933) (27,531)
Cash flows from financing activities:
Proceeds from issuance of preferred
stock in subsidiary 15,000 -
Proceeds from issuance of common stock, net 21,337 162,708
Principle and accrued interest payments on
revolving line of credit and long-term debt (540) 339
Proceeds (payments) under capital lease obligations 87 (650)
Net cash provided by financing activities 35,884 162,397
Net increase in cash and cash equivalents 11,756 78,708
Cash and cash equivalents at beginning of period 118,421 45,877
Cash and cash equivalents at end of period $130,189 $124,585
Supplemental cash flow information
Cash paid during the period for:
Interest $861 $835
Income taxes - -
See accompanying notes.
</TABLE>
AMERICA ONLINE, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
Note 1. Basis of Presentation
The accompanying unaudited condensed consolidated financial statements,
which include the accounts of America Online, Inc. (the "Company") and its
wholly and majority owned subsidiaries, have been prepared in accordance with
generally accepted accounting principles for interim financial information and
with the instructions to Form 10-Q and Article 10 of Regulation S-X.
Accordingly, they do not include all of the information and footnotes required
by generally accepted accounting principles for complete financial statements.
In the opinion of management, all adjustments, consisting only of normal
recurring accruals (with the exception of those adjustments discussed in Notes
3, 6 and 7 of the Notes to Consolidated Financial Statements), considered
necessary for a fair presentation, have been included in the accompanying
unaudited financial statements. All significant intercompany transactions and
balances have been eliminated in consolidation. Prior period financial
statements are restated for business combinations accounted for under the
pooling of interests method of accounting unless the effect of the business
combination is not material to the consolidated financial statements of the
Company. Certain amounts in prior years' consolidated financial statements have
been reclassified to conform to the current year presentation. Operating
results for the three and six months ended December 31, 1996 are not necessarily
indicative of the results that may be expected for the full year ending June 30,
1997. For further information, refer to the consolidated financial statements
and notes thereto, included in the Company's Annual Report on Form 10-K for the
fiscal year ended June 30, 1996.
Note 2. Stockholders' Equity
In October 1995, the Company completed a public stock offering of 4,963,266
shares of common stock (adjusted for a stock split) which generated net cash
proceeds of approximately $139,500,000.
During May 1996, the Company sold 1,000 shares of Series B convertible
preferred stock ("the Preferred Stock") for approximately $28,000,000. The
Preferred Stock has an aggregate liquidation preference of approximately
$28,000,000 and accrues dividends at a rate of 4% per annum. Accrued dividends
can be paid in the form of additional shares of Preferred Stock. During May
1998, the Preferred Stock, plus accrued but unpaid dividends, automatically
converts into shares of common stock based on the fair market value of common
stock at the time of conversion.
In November 1995, the Company effected a two-for-one split of the
outstanding shares of common stock. Accordingly, all data shown in the
accompanying consolidated financial statements and notes has been retroactively
adjusted to reflect the stock split.
Note 3. Change in Accounting Estimate
As a result of a change in accounting estimate, the Company recorded a
charge of $385,221,000, as of September 30, 1996, representing the balance of
deferred subscriber acquisition costs as of that date. The Company had
previously deferred the cost of certain marketing activities, to comply with the
criteria of Statement of Position 93-7 "Reporting on Advertising Costs", and
then amortized those costs over a period determined by calculating the ratio of
current revenues related to direct response advertising versus the total
expected revenues related to this advertising, or twenty-four months, whichever
was shorter. The Company's changing business model is expected to increasingly
reduce its reliance on online service subscriber revenues for the generation of
revenues and profits, by growing high-margin other revenue streams. These
changing market dynamics, coupled with a lack of historical experience with
flat-rate pricing, create uncertainties regarding the level of expected future
economic benefits from online service subscriber revenues (See "Management's
Discussion and Analysis of Financial Condition and Results of Operations"). As
a result, the Company believes it no longer has an adequate accounting basis to
support recognizing deferred subscriber acquisition costs as an asset.
Note 4. Income Taxes
The effective income tax rate varied from the federal statutory tax rate as
follows:
<TABLE>
Quarter Six Months
Ended Ended
12/31/96 12/31/96
<S> <C> <C>
Statutory rate (34.0%) (34.0%)
State income taxes - net of federal
income tax benefit (4.0) (4.0)
Valuation allowance on net deferred
tax benefit 38.0 38.0
Tax Rate -% -%
</TABLE>
Deferred income taxes arise because of differences in the treatment of
income and expense items for financial reporting and income tax purposes,
primarily relating to product development costs.
As of December 31, 1996, the Company had available net operating loss
carryforwards of approximately $533,000,000 for tax purposes, which will be
available, subject to certain annual limitations, to offset future taxable
income. If not used, these loss carryforwards will expire between 2001 and
2012. To the extent that net operating loss carryforwards, when realized,
relate to stock option deductions, the resulting benefits will be credited to
stockholders' equity.
Significant components of the Company's deferred tax liabilities and assets
as of December 31, 1996 are as follows:
<TABLE>
<S> <C>
Deferred tax liabilities:
Capitalized software costs $ 20,702,000
Net deferred tax liabilities $ 20,702,000
Deferred tax assets:
Net operating loss carryforward $245,046,000
Total deferred tax assets 245,046,000
Valuation allowance for deferred
assets (224,344,000)
Net deferred tax assets $ 20,702,000
</TABLE>
Note 5. Business Combinations
On August 5, 1996, the Company purchased 100% of the outstanding common
stock of the ImagiNation Network, Inc. ("INN"), by issuing 362,500 shares of its
common stock for a total purchase price of approximately $14.5 million. The
acquisition was accounted for under the purchase method and accordingly, the
assets and liabilities were recorded based upon their fair values at the date of
acquisition. The results of operations for the three and six months ended
December 31, 1996, include INN's operations from the date of acquisition.
The following pro forma information is not necessarily indicative of the
combined results that would have occurred had the acquisition taken place at the
beginning of the period, nor is it necessarily indicative of results that may
occur in the future.
<TABLE>
(in thousands, except per share data)
Pro Forma
Six months Six months
ended ended
12/31/96 12/31/95
(unaudited)
<S> <C> <C>
Revenues $ 759,394 $ 447,047
Income (loss) from operations (486,845) 1,916
Net loss (510,056) (7,621)
Loss per share $ (5.44) $ (0.09)
</TABLE>
Note 6. Legal Proceedings
Various legal proceedings have arisen against the Company in the ordinary
course of business. The Company is currently a party to numerous class action
lawsuits filed on behalf of subscribers who are seeking damages in connection
with difficulties in accessing the AOL service after the introduction of the
Flat-Rate Plan. The Company does not believe that these lawsuits will result in
a material liability for the Company.
In the quarter ended December 31, 1996, the Company recorded a one-time
charge of $24,300,000 related to a settlement reached with various State
Attorneys General, which pertained to difficulties certain subscribers
experienced in accessing the AOL service after the introduction of the Flat-Rate
Plan. The liability associated with this settlement resulted in refunds or
credits payable to qualifying subscribers to the AOL service.
In December 1996, the Company agreed with regulators to make additional
efforts to communicate to its subscribers information regarding the Company's
plan to change its pricing. This agreement resolved the concerns of the
regulators as reported in the Company's Form 10-Q for the quarter ended
September 30, 1996.
Note 7. Restructuring Charge
In connection with a restructuring plan adopted in the second quarter of
fiscal 1997, the Company recorded a $74,327,000 restructuring charge associated
with the Company's change in business model, the reorganization of the Company
into three operating units, the termination of approximately 300 employees, and
the shutdown of certain operating divisions and subsidiaries.
The components of the provision are as follows:
<TABLE>
<S> <C>
Write-off of impaired assets and
discontinued businesses $31,215,000
Contract terminations 27,098,000
Severance and personnel related 8,734,000
Other expenses 7,280,000
Total restructuring charge $74,327,000
</TABLE>
Included in the category of write-off of impaired assets and discontinued
businesses are the costs associated with the termination of the GNN service and
the write-off of the related goodwill. Additionally, the write-off of impaired
assets and discontinued businesses category includes charges associated with
unrealizable software development costs and certain prepaid marketing materials
which are no longer usable under the Company's new business model which includes
the flat-rate pricing structure. The contract terminations category consists of
costs associated with terminating certain usage-based contracts which are no
longer appropriate under the Company's current business model. The severance
and personnel related category includes the costs associated with terminating
approximately 300 employees. The other expenses category consists primarily of
costs incurred as a result of the requirements made by various regulatory bodies
in connection with the Company's termination of its former pricing program.
The following table summarizes the activity in the restructuring accrual
during the quarter ended December 31, 1996. The balance of the restructuring
accrual at December 31, 1996 is included in other accrued expenses and
liabilities on the balance sheet.
<TABLE>
<S> <C>
Restructuring charge $74,327,000
Payments (15,867,000)
Non-cash adjustments (19,937,000)
Restructuring accrual at December 31, 1996 $38,523,000
</TABLE>
Item 2. Management's Discussion and Analysis of Financial Condition and
Results of Operations
Overview
The following information should be read in conjunction with the
consolidated financial statements and the notes thereto included in Item 1 of
this Quarterly Report, and the consolidated financial statements and the notes
thereto and Management's Discussion and Analysis of Financial Condition and
Results of Operations contained in the Company's Annual Report on Form 10-K for
the year ended June 30, 1996.
The Company generates two types of revenues, online service revenues and
other revenues. Online service revenues are generated by customers subscribing
to the Company's online services. Other revenues are non-subscription based and
are generated from the Company's base of subscribers as well as businesses.
Other revenues include revenues from sources such as the sale of merchandise,
advertising, the provision of data network services and transaction fees.
The Company's online service revenues are generated primarily from
subscribers paying a monthly membership fee and, previous to December 1996,
hourly charges based on usage in excess of the number of hours of usage provided
as part of the monthly fee. Effective December 1, 1996, the Company began
offering several pricing alternatives aimed at providing price points for a wide
range of consumers. These pricing alternatives are as follows:
* A standard monthly membership fee providing complete access to AOL,
including the Internet, for a flat monthly fee of $19.95, with no additional
hourly charges (the "Flat-Rate Plan"). Subscribers can also choose to prepay
for two years in advance at the monthly rate of $14.95 or one year in advance
at the monthly rate of $17.95.
* An alternative offering three hours of AOL for $4.95 per month, with
additional time priced at $2.50 per hour.
* An alternative offering a rate of $9.95 per month for unlimited use of AOL
- for those subscribers who already have an Internet connection and use this
connection to access AOL.
Prior to December 1, 1996, the Company's standard monthly membership fee
for its AOL service, which included five hours of service, was $9.95 per month,
with a $2.95 hourly fee for usage in excess of five hours per month. Existing
members at December 1, 1996, could retain the $9.95 / five hour pricing upon
request. For the period July 1, 1996, through November 30, 1996, the Company
also offered a pricing plan which included 20 hours of service for $19.95 per
month, with a $2.95 hourly fee for usage in excess of 20 hours per month (the
"Value Plan"). The Value Plan was discontinued upon the the availability of the
Flat-Rate Plan on December 1, 1996.
As a result of the introduction of the Flat-Rate Plan for AOL and the
Internet, as detailed above, the Company's Internet service, Global Network
Navigator ("GNN"), will be discontinued prior to the end of fiscal 1997. The
Company had launched GNN in October 1995.
The growth of the Company's online service revenues is expected to be
driven in the near-term primarily by growth in its subscriber base. The growth
of the subscriber base is dependent upon the Company's ability to acquire and
retain subscribers. The Company acquires new subscribers to its services
through an introductory trial offer. The Company's ability to continue to
acquire new subscribers is dependent upon people continuing to register for its
introductory trial offer.
The Company experienced generally lower overall retention rates for
the AOL service during fiscal 1996 compared to fiscal 1995. Retention rates for
AOL subscribers who were early in their membership terms decreased more than the
overall retention rate, with the largest quarterly percentage decrease occurring
in the fourth quarter of fiscal 1996. The Company believes that factors
contributing to these decreases include: (1) the lack of a flat-rate pricing
plan for the AOL service and (2) an increase in less-qualified new subscribers
as a result of increased direct marketing to the mass consumer audience. The
Company believes that the introduction in July 1996 of the Value Plan, the new
version of AOL introduced in late fiscal 1996, and the introduction of the
Flat-Rate Plan on December 1, 1996, address many of the factors which most
directly affect retention. In addition, the Company plans to increase spending
on programs designed to improve trial conversion and retention rates. The
Company experienced sequentially higher retention rates in the first and second
quarters of fiscal 1997 compared to the fourth quarter of fiscal 1996.
Retention rates decreased in January 1997 relative to the average retention rate
for the second quarter of fiscal 1997. The Company believes that this decrease
is primarily a result of cancellations associated with the high number of
registrations that occurred in December 1996, cancellations associated with
network access problems experienced by certain subscribers, and cancellations
associated with the transition of subscribers to a higher standard monthly fee.
The average total usage hours per member per month, for AOL
subscribers, has increased in fiscal 1997 over fiscal 1996. The Company
believes that the principal factor contributing to this increase has been the
availability of the Value Plan through November 1996 and the Flat-Rate Plan
available thereafter, which have allowed members to spend more time online at
less cost. As a result, the Company has experienced an increase in the number of
hours of usage relative to online service revenues, and because the Company does
not have any historical operating experience with flat-rate pricing, there are
uncertainties regarding the level of future economic benefits from online
service subscriber revenues. Overall average monthly online service revenue
per AOL subscriber in fiscal 1997 is expected to be lower than in fiscal 1996.
Other revenues are generated primarily from the sale of merchandise,
advertising, data network services, and transaction fees. The growth of other
revenues is important to the Company's business objectives. In the second
quarter of fiscal 1997, other revenues represented approximately 14% of total
revenues. While such other revenues currently represent a relatively small
percentage of total revenues, a substantial portion of the Company's operating
margins are associated with these revenues. Among the Company's business
objectives are increasing the subscriber base and continuing to accelerate the
change in its business model into one in which increasingly more revenues and
profits are generated from sources other than online service subscription
revenues, such as merchandise sales, advertising, the provision of data network
services, and transaction fees, which generally carry higher margins than online
service revenues. The Company expects that the growth in other revenues,
assuming such growth continues, will be the primary source of future profit
growth, and will provide the Company with the opportunity and flexibility to
fund programs designed to grow the subscriber base and meet other business
objectives.
The online services and Internet markets are highly competitive. The
Company believes that existing competitors, which include, among others,
commercial Internet-based online services such as CompuServe, and Internet
service providers, such as Prodigy and the Microsoft Network, and including
various national and local independent Internet service providers as well as
long distance and regional telephone companies, including, among others, AT&T
Corporation, MCI Communications Corporation and various regional Bell operating
companies, are likely to enhance and more aggressively market their service
offerings. In addition, new competitors, including Internet directory services
and various media and telecommunications companies, have entered or announced
plans to enter the online services and Internet markets, resulting in greater
competition for the Company. Some of the direct competitors and possible future
competitors referred to above may have greater financial, technical, marketing
or personnel resources than the Company. The competitive environment
could have the following effects: require additional pricing programs and
increased spending on marketing, network capacity, content procurement and
product development; limit the Company's opportunities to enter into and/or
renew agreements with content providers and distribution partners; limit its
ability to develop new products and services; limit the Company's ability to
grow its subscriber base; and result in increased attrition in the Company's
subscriber base. Any of the foregoing events could have an impact on revenues
and result in an increase in costs as a percentage of revenues. These factors
may have a material adverse effect on the Company's financial condition and
operating results.
Results of Operations
Online Service Revenues
For the three months ended December 31, 1996, online service revenues
increased from $224,525,000 to $351,220,000, or 56%, over the three months ended
December 31, 1995. This increase was primarily attributable to a 60% increase in
the number of AOL North American subscribers. The average monthly online service
revenue per AOL North American subscriber decreased from $17.99 in the three
months ended December 31, 1995 to $16.95 in the three months ended December 31,
1996. This decrease was principally attributable to the availability of the
Value Plan in October and November 1996, and the Flat-Rate Plan in December
1996.
For the six months ended December 31, 1996, online service revenues
increased from $403,004,000 to $662,352,000, or 64%, over the six months ended
December 31, 1995. This increase was primarily attributable to a 60% increase in
the number of AOL North American subscribers. The average monthly online service
revenue per AOL North American subscriber decreased from $17.85 in the six
months ended December 31, 1995 to $16.90 in the six months ended December 31,
1996. This decrease was principally attributable to the availability of the
Value Plan from July 1996 through November 1996, and the Flat-Rate Plan in
December 1996.
Other Revenues
For the three months ended December 31, 1996, other revenues, consisting
principally of the sale of merchandise, advertising, data network services and
transaction fees increased from $24,620,000 to $58,192,000, or 136%, over the
three months ended December 31, 1995.
For the six months ended December 31, 1996, other revenues increased from
$44,043,000 to $97,042,000, or 120%, over the six months ended December 31,
1995. The increase in both periods was primarily attributable to an increase in
the sale of merchandise and advertising revenues.
Cost of Revenues
Cost of revenues includes network-related costs, consisting primarily of
data and voice communication costs, costs associated with operating the data
centers and providing customer support, royalties paid to information and
service providers, and the costs of merchandise sold. For the three months
ended December 31, 1996, cost of revenues increased from $145,928,000 to
$245,374,000, or 68%, over the three months ended December 31, 1995, and
increased as a percentage of total revenues from 58.6% to 59.9%. For the six
months ended December 31, 1996, cost of revenues increased from $265,005,000 to
$433,597,000, or 64%, over the six months ended December 31, 1995, and decreased
as a percentage of total revenues from 59.3% to 57.1%.
The increase in cost of revenues for the three and six month periods ended
December 31, 1996 was primarily attributable to an increase in data
communication costs, leased equipment costs, customer support costs, royalties
paid to information and service providers and the costs of merchandise sold.
Data communication costs increased primarily as a result of the larger customer
base and more usage by customers. Leased equipment costs increased primarily as
a result of additional host computer and network equipment. Customer support
costs, which include personnel and telephone costs associated with providing
customer support, were higher primarily as a result of the larger customer base.
Royalties paid to information and service providers increased as a result of a
larger customer base and more usage and the Company's addition of more service
content to broaden the appeal of the AOL service. The costs of merchandise sold
increased as a result of an increase in merchandise revenues.
The increase in cost of revenues as a percentage of total revenues for the
three months ended December 31, 1996 is primarily attributable to increases in
leased equipment costs, the costs of merchandise sold and royalties paid to
information and service providers. This increase was partially offset by a
decrease in data communication costs resulting from a lower cost per hour, due
to a higher percentage of traffic generated on the Company's lower cost network,
AOLnet.
The decrease in cost of revenues as a percentage of total revenues for the
six months ended December 31, 1996 is primarily attributable to a decrease in
data communication costs resulting from a lower cost per hour, due to a higher
percentage of traffic generated on AOLnet. This decrease was partially offset
by increases in leased equipment costs, the costs of merchandise sold and
royalties paid to information and service providers.
The Company is building AOLnet, a TCP/IP data network, in order to increase
its network capacity, provide its members with higher speed access, and reduce
the costs of data communication. As the Company rapidly builds AOLnet, it plans
to continue to manage an increasingly higher percentage of its total traffic to
this network, which would lead to greater network utilization and a lower
overall AOLnet per hour cost.
The Company expects that gross margins in the near future will be lower
than those achieved in recent periods. While the Company expects high-margin
other revenues will increase, and expects that the growth and management of
AOLnet will provide lower per hour data communication costs, it is anticipated
that these factors will be more than offset by an increase in the total usage
hours, primarily as a result of the introduction of the Flat-Rate Plan in
December 1996. Additionally, costs associated with the temporary renting of up
to 50,000 additional modems from outside suppliers, which will assist the
Company in meeting the demand for its online service, are expected to negatively
impact gross margins.
Marketing and Write-off of Deferred Subscriber Acquisition Costs
Marketing expenses include the costs to acquire and retain subscribers and
other general marketing costs. For the three months ended December 31, 1996,
marketing expenses increased from $52,158,000 to $146,777,000, or 181%, over the
three months ended December 31, 1995, and increased as a percentage of total
revenues from 20.9% to 35.9%. For the six months ended December 31, 1996,
marketing expenses increased from $89,082,000 to $222,649,000, or 150%, and
increased as a percentage of total revenues from 19.9% to 29.3%.
The increase in marketing expenses, and as a percentage of total revenues,
for the three and six month periods ended December 31, 1996, was primarily
attributable to a change in accounting estimate at September 30, 1996, which
resulted in subscriber acquisition costs being currently expensed for periods
subsequent to the first quarter of fiscal 1997, versus being capitalized and
amortized over twenty-four months in fiscal 1996 and in the first quarter of
fiscal 1997. In addition, the balance of deferred subscriber acquisition costs
as of September 30, 1996, totaling $385,221,000, was written off as a result of
this change in accounting estimate. For additional information regarding this
change, refer to Note 3 of the Notes to Consolidated Financial Statements.
For the three months ended December 31, 1996, marketing expenses, before
capitalization and amortization, increased from $108,805,000 to $146,777,000, or
35%, over the three months ended December 31, 1995, and decreased as a
percentage of total revenues from 43.7% to 35.9%. For the six months ended
December 31, 1996, marketing expenses, before capitalization and amortization,
increased from $201,255,000 to $293,689,000, or 46%, and decreased as a
percentage of total revenues from 45.0% to 38.7%.
The increase in marketing expenses for the three and six month periods
ended December 31, 1996, before capitalization and amortization, was primarily
attributable to an increase in the size and number of marketing programs
designed to expand the Company's subscriber base as well as an increase in
general marketing expenses. The decrease in marketing expenses as a percentage
of total revenues for the three and six month periods ended December 31, 1996,
before capitalization and amortization, was primarily the result of the
substantial growth in revenues, which more than offset the additional marketing
expenses.
Marketing expenses, and as a percentage of total revenues, are anticipated
to increase in fiscal 1997 over fiscal 1996. These anticipated increases are
primarily attributable to the change in accounting estimate, which will result
in a substantial portion of subscriber acquisition costs being currently
expensed in fiscal 1997, versus being capitalized and amortized over 24 months
in fiscal 1996.
Marketing expenses, before capitalization and amortization, are expected to
increase in fiscal 1997 over fiscal 1996. This anticipated increase is
primarily attributable to increased spending required to maintain and grow a
larger subscriber base. Marketing expenses as a percentage of total revenues,
before capitalization and amortization, are anticipated to decrease in fiscal
1997 over fiscal 1996. This anticipated decrease is primarily attributable to
the Company having a more competitively priced product offering.
Product Development
Product development costs include research and development expenses, other
product development costs and the amortization of software costs. For the three
months ended December 31, 1996, product development costs increased from
$10,330,000 to $21,673,000, or 110%, over the three months ended December 31,
1995, and increased as a percentage of total revenues from 4.1% to 5.3%. For the
six months ended December 31, 1996, product development costs increased from
$19,910,000 to $40,999,000, or 106%, over the six months ended December 31,
1995, and increased as a percentage of total revenues from 4.5% to 5.4%. The
increases in product development costs, and such costs as a percentage of total
revenues, were primarily attributable to increases in personnel costs related to
an increase in the number of technical employees and an increase in the
amortization of software costs. Product development costs, before
capitalization and amortization, increased by 75% and 81% in the three and six
months ended December 31, 1996, respectively.
General and Administrative
For the three months ended December 31, 1996, general and administrative
expenses increased from $23,986,000 to $48,810,000, or 103%, over the three
months ended December 31, 1995, and increased as a percentage of total revenues
from 9.6% to 11.9%. For the six months ended December 31, 1996, general and
administrative expenses increased from $44,466,000 to $84,374,000, or 90%, over
the six months ended December 31, 1995, and increased as a percentage of total
revenues from 9.9% to 11.1%. The increases in general and administrative costs,
and such costs as a percentage of total revenues, were principally attributable
to higher office-related expenses, related to an increase in the number of
employees as well as an increase in office space. This increase in office-
related expenses included costs associated with certain subsidiaries which were
present in the fiscal 1997 periods only, including Digital City, Inc. and INN.
Additionally, there were increases in professional services, personnel and
travel costs.
Acquired Research and Development
Acquired research and development costs, totaling $16,981,000 for the six
months ended December 31, 1995, relate to in-process research and development
purchased pursuant to the Company's acquisition of Ubique, Ltd. in September
1995.
Amortization of Goodwill
Goodwill is being amortized on a straight-line basis over periods ranging
from five to ten years. Amortization of goodwill decreased to $1,589,000 in the
three months ended December 31, 1996, from $1,749,000 in the three months ended
December 31, 1995. The decrease in amortization of goodwill is primarily
attributable to a write-off of the goodwill associated with GNN, partially
offset by goodwill associated with various purchases made by the Company,
including INN, all of which occurred subsequent to the second quarter of fiscal
1996. In connection with the fiscal 1997 second quarter restructuring charge
(see Note 7 of the Notes to Consolidated Financial Statements), the Company
wrote-off approximately $8.2 million of capitalized goodwill associated with
GNN.
Amortization of goodwill increased to $3,509,000 in the six months ended
December 31, 1996, from $3,412,000 in the three months ended December 31, 1995.
The increase in amortization of goodwill is primarily attributable to goodwill
associated with various purchases made by the Company, including INN, most of
which occurred subsequent to the second quarter of fiscal 1996, partially offset
by a reduction in goodwill associated with GNN.
Restructuring Charge
In connection with a restructuring plan adopted in the second quarter of
fiscal 1997, the Company recorded a $74,327,000 restructuring charge associated
with the Company's change in business model, the reorganization of the Company
into three operating units, the termination of approximately 300 employees, and
the shutdown of certain operating divisions and subsidiaries. For additional
information regarding this charge, refer to Note 7 of the Notes to Consolidated
Financial Statements.
Other Income (Expense)
Other income consists primarily of investment income and non-operating
gains net of interest expense and non-operating charges. The Company had other
expense of $1,367,000 and other income of $1,460,000 in the three months ended
December 31, 1996 and 1995, respectively. The Company had other income of
$1,088,000 and $2,292,000 in the six months ended December 31, 1996 and 1995,
respectively. The change in other income (expense) for the three months ended
December 31, 1996, was primarily attributable to non-operating losses related to
various investments and a decrease in investment income partially offset by the
allocation of minority interest losses. The decrease in other income for the
six months ended December 31, 1996 was primarily attributable to non-operating
losses related to various investments partially offset by the allocation of
minority interest losses.
Settlement Charge
In the quarter ended December 31, 1996, the Company recorded a one-time
charge of $24,300,000 related to a settlement reached with various State
Attorneys General, which pertained to difficulties certain subscribers
experienced in accessing the AOL service after the introduction of the Flat-Rate
Plan. The liability associated with this settlement resulted in refunds or
credits payable to qualifying subscribers to the AOL service.
Provision for Income Taxes
The provision for income taxes was $0 and $6,924,000 in the three months
ended December 31, 1996 and 1995, respectively and $0 and $11,860,000 in the six
months ended December 31, 1996 and 1995, respectively. For additional
information regarding income taxes, refer to Note 4 of the Notes to Consolidated
Financial Statements.
Net Income (Loss)
The net loss was $154,805,000 in the three months ended December 31, 1996,
compared to net income of $9,530,000 in the three months ended December 31,
1995. The net loss was $508,494,000 and $1,377,000 in the six months ended
December 31, 1996 and 1995, respectively. The net loss in the three months
ended December 31, 1996 included a restructuring charge of $74,327,000 and a
settlement charge of $24,300,000. The net loss in the six months ended December
31, 1996 included a charge of $385,221,000 for the write-off of deferred
subscriber acquisition costs. The net loss in the six months ended December 31,
1995 included a charge of $16,981,000 for acquired research and development.
Liquidity and Capital Resources
The Company has financed its operations through cash generated from
operations and the sale of its capital stock. The Company has financed its
investments in facilities and telecommunications equipment principally through
leasing. Net cash provided by (used in) operating activities was $18,817,000
and $(56,158,000) in the six months ended December 31, 1996 and 1995,
respectively. Included in operating activities were expenditures for deferred
subscriber acquisition costs of $130,229,000 and $153,317,000 in the six months
ended December 31, 1996 and 1995, respectively, as well as an increase in other
accrued expenses and liabilities of $118,717,000 in the six months ended
December 31, 1996, principally related to accruals associated with the
restructuring charge (refer to Note 7 of the Notes to Consolidated Financial
Statements), an increase in telecommunications accruals, and the accrual of the
settlement charge (refer to Note 6 of the Notes to Consolidated Financial
Statements). Net cash used in investing activities was $42,933,000 and
$27,531,000 in the six months ended December 31, 1996 and 1995, respectively.
Net cash provided by financing activities was $35,884,000 and $162,397,000 in
the six months ended December 31, 1996 and 1995, respectively. Included in
financing activities was $15,000,000 in the six months ended December 31, 1996
representing proceeds from the sale of preferred stock in a subsidiary
corporation, and approximately $139,500,000 in the six months ended December 31,
1995 representing proceeds from a public stock offering of common stock.
In May 1996, the Company entered into a joint venture with Mitsui & Co.,
Ltd. (Mitsui) and Nihon Keizai Shimbun, Inc. (Nikkei) to offer interactive
online services in Japan. In connection with the agreement, the Company
received approximately $28,000,000 through the sale of convertible preferred
stock to Mitsui. The preferred stock has an aggregate liquidation preference of
approximately $28,000,000 and accrues dividends at a rate of 4% per annum.
Accrued dividends can be paid in the form of additional shares of preferred
stock. During May 1998, the preferred stock, together with accrued but unpaid
dividends, automatically converts into shares of common stock based on the fair
market value of common stock at the time of conversion.
The Company leases the majority of its facilities and equipment under non-
cancelable operating leases, and is building AOLnet, its data communications
network, as well as expanding its host server and data center capacity. The
buildout of AOLnet and the expansion of host server and data center capacity
requires a substantial investment in telecommunications and server equipment, as
well as facilities, which the Company plans to finance principally through
leasing and asset-backed debt financing. The Company plans to make investment
commitments of up to $350,000,000 in the second half of fiscal 1997 in order to
increase its network, host server and data center capacity.
The Company uses its working capital to finance ongoing operations and to
fund marketing and content programs and the development of its products and
services. The Company plans, after a short-term slowdown in marketing while the
Company increases its network capacity, to continue to invest aggressively in
subscriber acquisition marketing and content programs to expand its subscriber
base, as well as in network, computing and support infrastructure.
Additionally, the Company expects to use a portion of its cash for the
acquisition and subsequent funding of technologies, content, products or
businesses complementary to the Company's current business. The Company
anticipates that available cash and cash provided by operating activities will
be sufficient to fund its operations for the next twelve months, including
certain costs associated with the fiscal 1997 second quarter restructuring and
settlement charges.
Seasonality
In April 1996, the Company began to see the effects of seasonality in both
member acquisitions and in the amount of time spent by customers using its
services. The Company may have experienced the effects of seasonality in
previous periods, but the effects, if any, were not discernible due to the
masking effect resulting from the Company's substantial growth rates in those
periods. The Company expects that seasonality will have an effect in the
future. The growth in the subscriber base is expected to be highest in the
second and third fiscal quarters, when sales of new computers and computer
software are highest due to the holiday season. Customer usage is expected to
be lower in the summer months due largely to extended daylight hours and
competing outdoor leisure activities.
Inflation
The Company believes that inflation has not had a material effect on its
results of operations.
Forward-Looking Statements
In connection with the "safe harbor" provisions of the Private Securities
Litigation Reform Act of 1995, the Company wishes to caution readers that the
following important factors could cause the Company's actual results to differ
materially from those projected in forward-looking statements made by, or on
behalf of, the Company:
Factors related to increased competition from existing and new competitors,
including price reductions and increased spending on marketing, network
capacity, content procurement and product development; limitations on the
Company's opportunities to enter into and/or renew agreements with content
providers and distribution partners; limitations on its ability to develop new
products and services; limitations on its ability to continue to grow its
subscriber base; increased membership acquisition costs; lower average monthly
revenue per subscriber and increased attrition in the Company's subscriber base.
Factors related to the new standard monthly membership fee (the Flat-Rate
Plan), and other new pricing alternatives, which became available December 1,
1996, including uncertainty of: the effect on average cost per subscriber
acquisition and retention rates; the amount of time spent by members using the
AOL service under each pricing alternative; and the percentage of members who
sign up under each pricing alternative relative to their usage patterns.
Risks related to the buildout of AOLnet and the expansion of host server
and data center capacity, including the inability to expand network, host server
and data center capacity at a rate to sufficiently satisfy subscriber demands,
which accelerated substantially as a result of the introduction of flat-rate
pricing; the failure of any of the Company's network providers; the failure to
procure certain component parts required to expand AOLnet capacity, and for
which supply shortages currently exist, including modems, circuits, routers, and
local exchange carrier lines from local telephone companies; the failure to
obtain the necessary financing for the buildout of AOLnet and the expansion of
host server and data center capacity; and the risk that demand will not develop
for the capacity AOLnet will provide.
Any damage or failure to the Company's computer equipment and the
information stored in its data centers, such as damage by fire, power loss,
telecommunications failures, unauthorized intrusions and other events, that
causes interruptions in the Company's operations, or any interruptions or
service outages caused by software defects or server and network expansion.
The Company's inability to manage its growth and to adapt its
administrative, operational, customer support and financial control systems to
the needs of the expanded entity and subscriber base; and the failure of
management to anticipate, respond to and manage changing business conditions.
The failure of the Company or its partners to successfully market, sell and
deliver its services in international markets; and risks inherent in doing
business on an international level, such as laws governing content that differ
greatly from those in the U.S., unexpected changes in regulatory requirements,
political risks, export restrictions, export controls relating to encryption
technology, tariffs and other trade barriers, fluctuations in currency exchange
rates, issues regarding intellectual property and potentially adverse tax
consequences.
The possibility of a moderating growth rate in the sale of new computers in
the U.S. and, to some extent, internationally; general or specific economic
conditions; the ability and willingness of purchasers to substitute other
services for AOL; the perceived absolute or relative overall value of these
services by the purchasers, including the features, quality and pricing compared
to other competitive services; smaller market or slowing of market growth for
such services.
The amount and rate of growth in the Company's marketing and general and
administrative expenses; the implementation of new marketing programs and
promotional offers; the implementation of additional pricing programs; and the
impact of unusual items resulting from the Company's ongoing evaluation of its
business strategies, asset valuations and organizational structures.
Difficulties or delays in the development, production, testing and
marketing of products, including, but not limited to, a failure to ship new
products and technologies when anticipated, including, but not limited to, new
client software and new features and functionality, and the failure to develop
new technology or modify existing technology to incorporate new standards and
protocols.
The acquisition of businesses, fixed assets and other assets and
acquisition related risks, including successful integration and management of
acquired technology, operations and personnel, the loss of key employees of the
acquired companies, and diversion of management attention from other ongoing
business concerns; the making or incurring of any expenditures and expenses,
including, but not limited to, depreciation and significant charges for in-
process research and development or other matters; and any revaluation of assets
or related expenses.
The ability of the Company to diversify its sources of revenue through the
introduction of new products and services and through the development of new
revenue sources, such as merchandise sales, advertising, the provision of data
network services and transactions.
The effects of, and changes in, trade, monetary and fiscal policies, laws
and regulations, other activities of governments, agencies and similar
organizations, and social and economic conditions, such as trade restrictions or
prohibitions, inflation and monetary fluctuations, import and other charges, or
federal, state, local and other taxes.
The loss of the services of executive officers and other key employees; and
the Company's continued ability to attract and retain highly skilled and
qualified personnel.
The costs and other effects of litigation, governmental investigations,
legal and administrative cases and proceedings (whether civil, such as
environmental and product-related, or criminal), settlements, judgments and
investigations, claims, and changes in those items, and developments or
assertions by or against the Company relating to intellectual property rights
and intellectual property licenses.
Adoptions of new, or changes in, accounting policies, practices and
estimates and the application of such policies, practices and estimates.
The effects of any activities of parties with which the Company has an
agreement or understanding, including any issues affecting any investment or
joint venture in which the Company has an investment; the amount, type and cost
of the financing which the Company has, and any changes to that financing.
PART II. OTHER INFORMATION
Item 1. Legal Proceedings
Various legal proceedings have arisen against the Company in the
ordinary course of business. The Company is currently a party to numerous
class action lawsuits filed on behalf of subscribers who are seeking
damages in connection with difficulties in accessing the AOL service after
the introduction of the Flat-Rate Plan. The Company does not believe that
these lawsuits will result in a material liability for the Company.
In the quarter ended December 31, 1996, the Company recorded a one-
time charge of $24,300,000 related to a settlement reached with various
State Attorneys General, which pertained to difficulties certain
subscribers experienced in accessing the AOL service after the
introduction of the Flat-Rate Plan. The liability associated with this
settlement resulted in refunds or credits payable to qualifying
subscribers to the AOL service.
In December 1996, the Company agreed with regulators to make
additional efforts to communicate to its subscribers information regarding
the Company's plan to change its pricing. This agreement resolved the
concerns of the regulators as reported in the Company's Form 10-Q for the
quarter ended September 30, 1996.
Item 4. Submission of Matters to a Vote of Security Holders
On October 31, 1996 the Company submitted various matters to a vote of
its shareholders at its Annual Meeting of Shareholders. A brief
description of matters voted upon at the Meeting and the results of the
voting follows:
(1) To elect three members to the Board of Directors to serve for a term
ending in 1999 and until their successors are duly elected and
qualified.
Stephen M. Case, William N. Melton and Thomas Middelhoff were elected
to the Board of Directors to serve for a three year period ending in
1999.
(2) To consider and act upon a proposal to ratify the appointment of
Ernst & Young LLP as the Company's independent public accountants for
the fiscal year ending June 30, 1997.
For 79,150,888
Against 312,079
Abstain 70,414
Item 6. Exhibits and Reports on Form 8-K
(a) Exhibits
None
(b) Reports on Form 8-K
Form Item # Description Filing Date
Form 8-K/A 7 Amendment of a Current Report October 21, 1996
on Form 8-K filed on August 20,
1996 to add financial statements
and exhibits
Form 8-K 5, 7 Press Release regarding the November 6, 1996
Registrant's decision to expense
all of its marketing costs as
they are incurred rather than
amortizing certain marketing
expenses
AMERICA ONLINE, INC.
SIGNATURES
Pursuant to the requirements of the Securities Exchange Act of 1934, the
registrant has duly caused this report to be signed on its behalf by the
undersigned thereunto duly authorized.
AMERICA ONLINE, INC.
DATE: February 14, 1997 SIGNATURE: /s/Stephen M. Case
Stephen M. Case
Chief Executive Officer
DATE: February 14, 1997 SIGNATURE: /s/Lennert J. Leader
Lennert J. Leader
Chief Financial Officer
(Principal Financial and Accounting
Officer)
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