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, 1997
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
incorporation or organization) Identification No.)
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, 1998 105,105,940
AMERICA ONLINE, INC.
INDEX
Page
PART I. FINANCIAL INFORMATION
Item 1. Consolidated Financial Statements
Consolidated Balance Sheets-December 31, 1997
and June 30, 1997 3
Consolidated Statements of Operations-Three
months ended December 31, 1997 and 1996 4
Consolidated Statements of Operations-Six
months ended December 31, 1997 and 1996 4
Consolidated Statements of Cash Flows-Six
months ended December 31, 1997 and 1996 5
Consolidated Statement of Changes in
Stockholders' Equity - Six months ended
December 31, 1997 6
Notes to Consolidated Financial Statements 7
Item 2. Management's Discussion and Analysis of Financial Condition
and Results of Operations 9
PART II. OTHER INFORMATION
Signatures 21
AMERICA ONLINE, INC. AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEETS
(Amounts in thousands, except share data)
<TABLE>
December 31, June 30,
1997 1997
ASSETS (Unaudited)
Current assets:
<S> <C> <C>
Cash and cash equivalents $ 581,200 $ 124,340
Short-term investments 236 268
Trade accounts receivable,net 86,718 65,306
Other receivables 31,130 26,093
Prepaid expenses and other current assets 81,150 107,466
Total current assets 717,434 323,473
Property and equipment at cost, net 336,097 233,129
Other assets:
Restricted cash - 50,000
Product development costs, net 83,635 72,498
License rights,net 13,890 16,777
Investments including available-for-sale
securities 97,513 48,267
Other assets 43,694 36,351
Deferred income taxes 48,165 24,410
Goodwill, net 42,733 41,783
Total assets $1,383,161 $ 846,688
LIABILITIES AND STOCKHOLDERS' EQUITY
Current liabilities:
Trade accounts payable $ 68,485 $ 69,703
Other accrued expenses and liabilities 301,275 297,298
Deferred revenue 174,392 166,007
Accrued personnel costs 31,385 20,008
Current portion of long-term debt and
capital lease obligations 1,971 1,454
Total current liabilities 577,508 554,470
Long-term liabilities:
Notes payable 371,391 50,000
Deferred income taxes 48,165 24,410
Deferred revenue 79,384 86,040
Minority interests 313 2,674
Other liabilities 843 1,060
Total liabilities 1,077,604 718,654
Stockholders' equity:
Preferred stock, $.01 par value; 5,000,000
shares authorized, 1,000 shares issued and
outstanding at December 31, 1997 and
June 30, 1997 1 1
Common stock, $.01 par value, 300,000,000
shares authorized, 104,214,103 and 100,188,971
shares issued and outstanding at December 31,
1997 and June 30, 1997, respectively 1,042 1,002
Additional paid-in-capital 738,991 617,221
Unrealized gain on available-for-sale
securities 32,705 16,924
Accumulated deficit (467,182) (507,114)
Total stockholders' equity 305,557 128,034
Total liabilities and stockholders'
equity $1,383,161 $ 846,688
See accompanying notes.
</TABLE>
AMERICA ONLINE, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF OPERATIONS
(amounts in thousands, except per share data)
<TABLE>
Three months
ended
December 31,
1997 1996
(Unaudited) (Unaudited)
Revenues:
<S> <C> <C>
Online service revenues $ 483,165 $ 351,220
Advertising, commerce and other
revenues 108,831 58,192
Total revenues 591,996 409,412
Costs and expenses:
Cost of revenues 385,986 261,888
Marketing 96,820 151,834
Product development 23,632 19,755
General and administrative 50,663 29,157
Amortization of goodwill 2,161 1,589
Restructuring charge - 48,627
Settlement charge (1,009) 24,300
Total costs and expenses 558,253 537,150
Income (loss) from operations 33,743 (127,738)
Other income (expense), net 741 (1,367)
Income (loss) before provision for
income taxes 34,484 (129,105)
Provision for income taxes (13,716) -
Net income (loss) $20,768 $(129,105)
Earnings (loss) per share-diluted $ 0.17 $ (1.37)
Earnings (loss) per share-basic $ 0.20 $ (1.37)
Weighted average shares outstanding-diluted 120,379 94,284
Weighted average shares outstanding-basic 103,184 94,284
See accompanying notes.
</TABLE>
AMERICA ONLINE, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF OPERATIONS
(amounts in thousands, except per share data)
<TABLE>
Six months
ended
December 31,
1997 1996
(Unaudited) (Unaudited)
Revenues:
<S> <C> <C>
Online service revenues $ 917,332 $662,352
Advertising, commerce and other
revenues 196,302 97,042
Total revenues 1,113,634 759,394
Costs and expenses:
Cost of revenues 712,987 463,042
Marketing
Marketing 194,622 230,977
Write-off of deferred subscriber
acquisition costs - 385,221
Product development 39,447 38,339
General and administrative 104,974 49,261
Amortization of goodwill 3,837 3,509
Restructuring charge (1,306) 48,627
Settlement charge (1,009) 24,300
Total costs and expenses 1,053,552 1,243,276
Income (loss) from operations 60,082 (483,882)
Other income, net 6,068 1,088
Income (loss) before provision for
income taxes 66,150 (482,794)
Provision for income taxes (26,218) -
Net income (loss) $ 39,932 $(482,794)
Earnings (loss) per share-diluted $ 0.33 $ (5.15)
Earnings (loss) per share-basic $ 0.39 $ (5.15)
Weighted average shares outstanding-
diluted 119,376 93,727
Weighted average shares outstanding-
basic 102,119 93,727
See accompanying notes.
</TABLE>
AMERICA ONLINE, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASH FLOWS
(Amounts in thousands)
<TABLE>
Six months
ended
December 31,
1997 1996
(Unaudited)
Cash flows from operating activities:
<S> <C> <C>
Net income (loss) $ 39,932 $(482,794)
Adjustments to reconcile net income (loss)
to net cash provided by operating activities:
Write-off of deferred subscriber
acquisition costs - 385,221
Non-cash restructuring charges (2,315) 19,937
Depreciation and amortization 56,843 28,363
Amortization of subscriber acquisition costs - 59,189
Compensatory stock options 23,629 -
Deferred income taxes 26,218 -
Changes in assets and liabilities:
Trade accounts receivable (21,480) (3,258)
Other receivables (4,260) 4,435
Prepaid expenses and other current assets 26,383 (18,690)
Deferred subscriber acquisition costs - (130,229)
Other assets (22,562) (5,976)
Trade accounts payable (1,064) 27,211
Accrued personnel costs 11,401 (6,241)
Other accrued expenses and liabilities 19,985 93,017
Deferred revenue 1,729 57,472
Other liabilities (217) (255)
Total adjustments 114,290 510,196
Net cash provided by operating activities 154,222 27,402
Cash flows from investing activities:
Purchase of property and equipment (153,323) (29,779)
Product development costs (26,994) (31,976)
Other investing activities (2,345) 10,237
Net cash used in investing activities (182,662) (51,518)
Cash flows from financing activities:
Proceeds from issuance of preferred stock
in subsidiary - 15,000
Proceeds from issuance of common stock, net 51,025 21,337
Proceeds (payments) on long-term debt 735 (540)
Proceeds from notes payable, net 370,625 -
Proceeds (payments) under capital lease
obligations (85) 87
Restricted cash 50,000 -
Payments on line of credit (50,000) -
Net cash provided by financing activities 422,300 35,884
Net increase in cash and cash equivalents 393,860 11,768
Cash and cash equivalents at beginning of period 124,340 118,421
Cash and cash equivalents at end of period $518,200 $130,189
Supplemental cash flow information
Cash paid during the period for:
Interest $4,177 $ 861
Income taxes - -
See accompanying notes.
</TABLE>
AMERICA ONLINE, INC. AND SUBSIDIARIES
Consolidated Statement of Changes in Stockholders' Equity
(Amounts in thousands, except share data)
(unaudited)
<TABLE>
Preferred Stock Common Stock
Shares Amount Shares Amount
<S> <C> <C> <C> <C>
Balances at June 30, 1997 1,000 $ 1 100,188,971 $1,002
Common stock issued:
Exercise of options - - 3,924,164 40
Business acquisitions 33,724 -
Sale of stock, net 67,244 -
Amortization of deferred compensation
Tax benefit related to stock options
Unrealized gain on available-for-sale
securities
Net income - - - -
Balances at December 31, 1997 1,000 $ 1 104,214,103 $1,042
Unrealized
gain on
Additional available-for-
Paid-in sale Accumulated
Capital securities Deficit Total
<S> <C> <C> <C> <C>
Balances at June 30, 1997 $617,221 $ 16,924 $(507,114) $128,034
Common stock issued:
Exercise of options 45,993 - - 46,033
Business acquisitions 2,866 2,866
Sale of stock 2,986 2,986
Amortization of deferred
compensation 23,629 23,629
Tax benefit related to stock
options 26,218 26,218
Unrealized gain on available-for-
sale securities 20,078 15,781 35,859
Net income - - 39,932 39,932
Balances at December 31, 1997 $738,991 $32,705 $(467,182) $305,557
See accompanying notes.
</TABLE>
AMERICA ONLINE, INC.
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 the adjustment discussed in Note 2 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. 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,
1997 are not necessarily indicative of the results that may be expected for the
full year ending June 30, 1998. 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, 1997.
In January 1997, the Securities and Exchange Commission issued new rules
requiring disclosure of the Company's accounting policies for derivatives and
market risk disclosure. The Company does not have any derivative financial
instruments as of December 31, 1997, and believes that the interest rate risk
associated with its borrowings and market risk associated with its available-
for-sale securities are not material to the results of operations or financial
position of the Company.
Note 2. Change in Accounting Estimate
As a result of a change in accounting estimate, the Company recorded a
charge of $385.2 million 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, which includes flat-rate
pricing for its online service, is expected to reduce its reliance on online
service subscriber revenues for the generation of revenues and profits. This
changing business model, coupled with a lack of historical experience with flat-
rate pricing, created 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 believed it no longer had an adequate accounting basis to
support recognizing deferred subscriber acquisition costs as an asset.
Note 3. Income Taxes
The effective income tax rate varied from the federal statutory tax rate as
follows:
<TABLE>
Three Months Six Months
Ended Ended
12/31/97 12/31/97
<S> <C> <C>
Statutory rate 35.0% 35.0%
State income taxes - net of federal
income tax benefit 3.0 3.0
Other 1.8 1.6
Effective tax rate 39.8% 39.6%
</TABLE>
As of December 31, 1997, the Company had available net operating loss
carryforwards of approximately $969.4 million 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. (See Note 7, Subsequent Events)
Deferred income taxes arise because of differences in the treatment of
income and expense items for financial reporting and income tax purposes.
Deferred income taxes reflect the net tax effects of temporary differences
between the carrying amounts of assets and liabilities for financial reporting
purposes and the amounts used for income tax purposes. Significant components
of the Company's deferred tax liabilities and assets as of December 31, 1997 and
1996 are as follows:
<TABLE>
December 31,
(In thousands) 1997 1996
<S> <C> <C>
Deferred tax liabilities:
Capitalized software costs $28,087 $20,702
Unrealized gain on available-for-sale securities 20,078 -
Net deferred tax liabilities $48,165 $20,702
Deferred tax assets:
Net operating loss carryfowards $ 368,389 $221,996
Other 7,217 14,107
Total deferred tax assets 375,606 236,103
Valuation allowance for deferred assets (327,441) (215,401)
Net deferred tax assets $ 48,165 $ 20,702
</TABLE>
Note 4. Legal Proceedings
The Company is involved in various legal proceedings, including pending
litigation. In February 1997, a class action lawsuit (Orman v. America Online,
Inc., et al.) was filed against the Company, its officers and directors and its
outside auditors alleging violations of the federal securities laws between
August 10, 1995 and October 29, 1996. In July 1997, the court dismissed the
complaint, finding that the allegations of the complaint were not sufficiently
specific. The plaintiffs filed an amended complaint in September 1997, this
time naming only the Company, its Chief Executive Officer and its Chief
Financial Officer as defendants. The court has declined to dismiss the amended
complaint and the case is scheduled to be tried during 1998. A shareholder
derivative suit related to the Orman lawsuit has also been filed in Delaware
chancery court against certain current and former directors of the Company.
The Company, one of its subsidiaries and two officers are named in a
lawsuit alleging, among other matters, that the Company breached an agreement
and has monopolized and attempted to monopolize an alleged market for online
games. The complaint seeks $100 million in damages and requests other relief.
The Company believes that it has valid defenses to all litigation pending
against it, and all cases against the Company are, and will continue to be,
vigorously defended. Management is unable to make a meaningful estimate of the
amount or range of loss that could result from an unfavorable outcome of all
pending litigation. It is possible that the Company's operating results or cash
flows in a particular quarter or annual period or its financial position could
be materially affected by an ultimate unfavorable outcome of certain pending
litigation. Management believes, however, that the ultimate outcome of all
pending litigation should not have a material adverse effect on the Company's
operating results, cash flows or financial position.
Note 5. Notes Payable
During September 1997, the Company borrowed $28.5 million in a refinancing
of one of its office buildings. The note is collateralized by the Company's
office building and carries interest at a fixed rate of 7.46%. The note
amortizes on a straight-line basis over a term of 25 years and if not paid in
full at the end of 10 years the interest rate, from that point forward, is
subject to adjustment.
On November 17, 1997, the Company sold $350 million of 4% Convertible
Subordinated Notes due November 15, 2002 (the "Notes"). The Notes are
convertible into the Company's common stock at a conversion rate of 9.5797
shares of common stock for each $1,000 principal amount of the notes (equivalent
to a conversion price of $104.3875 per share), subject to adjustment in certain
events. Interest on the Notes is payable semiannually on May 15 and November 15
of each year, commencing on May 15, 1998. The Notes may be redeemed at the
option of the Company on or after November 14, 2000, in whole or in part, at the
redemption prices set forth in the Notes. For additional information regarding
the Notes, refer to Part II, Item 2.
Note 6. Barter Transactions
The Company barters advertising on the AOL service for products and
services. Such transactions are recorded at the estimated fair value of the
products or services received. Revenue from barter transactions is recognized
when advertising is provided, and services received are charged to expense when
used.
Note 7. Subsequent Events
On January 9, 1998, the Company acquired Personal Library Software, Inc., a
developer of information indexing and search technologies, in a transaction that
will be accounted for under the purchase method of accounting. The total
purchase price was approximately $15 million, comprised of approximately $9
million in stock and $6 million in assumed liabilities. In connection with this
transaction, the Company expects to record a charge for acquired in-process
research and development of approximately $9 million in the quarter ending March
31, 1998.
On January 31, 1998, the Company consummated a Purchase and Sale Agreement
(the "Purchase and Sale") by and among the Company, ANS Communications, Inc.
("ANS"), a then wholly-owned subsidiary of the Company, and WorldCom, Inc.
("WorldCom") pursuant to which the Company transferred to WorldCom all of the
issued and outstanding capital stock of ANS in exchange for $175 million ($162
million in cash after purchase price adjustments made at closing), and the
online services business of Compuserve Corporation, which was acquired by
WorldCom shortly before the consummation of the Purchase and Sale. Immediately
after the consummation of the Purchase and Sale the Company's European partner,
Bertelsmann AG, paid $75 million to the Company for a 50% interest in a newly
created joint venture to operate the CompuServe European online service. Each
company invested an additional $25 million in cash in this joint venture. The
Company generated approximately $212 million in cash as a result of the
aforementioned transactions. Concurrently with the Purchase and Sale the
Company also entered into a five year network services agreement with WorldCom
which provides the Company with significantly expanded network capacity for the
Company's online service at favorable prices, comparable to those expected to be
paid as a network owner/operator. In connection with these transactions, the
Company expects to realize a gain of $350 million to $400 million, which will be
recognized on a straight-line basis as a reduction of cost of revenues over the
five-year term of the network services agreement with WorldCom.
At December 31, 1997, ANS had assets of $101.1 million (including $1.1
million in intercompany receivables), liabilities of $55.6 million and
stockholders' equity of $45.5 million. The major components of assets were
$36.9 million in property and equipment and $31.3 million in goodwill. The major
component of liabilities was $46.9 million in other accrued expenses and
liabilities. For the quarter ended December 31, 1997, ANS' third party revenues
(excluding intercompany revenues) totaled $14.1 million and are included in
advertising, commerce and other revenues in the Consolidated Statements of
Operations.
On February 6, 1998, the Company's stockholders approved an amendment to
the Company's Restated Certificate of Incorporation to increase the authorized
number of shares of common stock from 300,000,000 to 600,000,000.
The Company announced on February 9, 1998, that it will increase the price
of its Flat-Rate Plan for the AOL service by $2.00 per month to $21.95 per
month, in order to fund continued improvement of members' online experience and
to keep pace with the cost of members' increased usage. The price increase will
become effective at the start of each members' monthly billing cycle in April
1998. In addition, members may choose to pay for one year in advance at the
monthly rate of $19.95, a $2.00 per month increase from the previous annual plan
rate. Those subscribers who are currently on the annual plan will not be
subject to an increase until their renewal date. The Company will continue to
offer its other pricing plans with no changes.
Also on February 9, 1998, the Company announced a series of organizational
and management changes, including: organizing the Company's operations into
three brand groups supported by certain common infrastructure services; and
forming AOL Investments to manage the Company's investment portfolio. In
connection with the Company's reorganization into three brand groups, the
Company expects to incur a restructuring charge not to exceed $25 million in the
quarter ending March 31, 1998. Principal items expected to be included in the
charge are severance and related benefits for staff reductions, lease and
contract terminations, and other costs.
On February 10, 1998, the Company's Board of Directors approved a two-for-
one common stock split, to be effected by dividending one additional share for
each share owned on the record date, February 23, 1998. The payment date for
the stock split is March 16, 1998. The impact of the stock split is not
reflected in the accompanying financial statements.
Beginning with the three months ending March 31, 1998, the Company will
change its method of accounting for income taxes. Prior to January 1, 1998, the
Company followed the practice of computing its tax provision on the assumption
that stock option deductions were used first to offset its financial statement
income, providing a charge in lieu of tax and crediting the resulting benefit to
stockholders' equity. The Company will change its accounting for income taxes
to recognize the tax benefits from stock option deductions after consideration
of temporary differences and net operating losses determined without deduction
for stock option plans. Based on the information available, the Company's
provision for income taxes for the six months ended December 31, 1997 would be
substantially eliminated due to the change in accounting for income taxes being
retroactive to July 1, 1997.
Note 8. Recent Pronouncements
In June 1997, the Financial Accounting Standards Board ("FASB") issued
Statement of Financial Accounting Standard ("SFAS") No. 130, "Reporting
Comprehensive Income" which requires companies to report by major components and
in total, the change in its net assets during the period from non-owner sources.
The FASB also issued SFAS No. 131, "Disclosures about Segments of an Enterprise
and Related Information," which establishes annual and interim reporting
standards for a company's operating segments and related disclosures about its
products, services, geographic areas and major customers. Both Statements are
effective for fiscal years beginning after December 15, 1997. Adoption of these
standards will not impact the Company's consolidated financial position, results
of operations or cash flows, and any effect, while not yet determined by the
Company, will be limited to the presentation of its disclosures.
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, 1997.
The Company generates two types of revenues, online service revenues and
advertising, commerce and other revenues. Online service revenues are generated
from customers subscribing to the Company's online services. Advertising,
commerce and other revenues are non-subscription based and are generated from
the Company's base of subscribers as well as businesses. Advertising, commerce
and other revenues consist of the sale of merchandise, advertising and related
revenues, and transaction fees associated with electronic commerce, as well as
other revenues, which consist primarily of data network service revenues.
Currently, the Company's online service revenues are generated primarily
from subscribers paying a monthly membership fee. Prior to December 1, 1996, a
significant portion of online service revenues were comprised of hourly charges
based on usage in excess of the number of hours of usage provided as part of the
monthly fee. With the introduction of flat-rate pricing, as described below,
the portion of online service revenues which are generated from hourly charges
has decreased substantially.
The growth of the Company's online service revenues, assuming such growth
continues, is expected to be driven 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.
Effective December 1, 1996, the Company began offering several pricing
alternatives to the AOL service aimed at providing price points for a wide range
of consumers. These pricing alternatives are as follows:
* A standard monthly membership fee of $19.95, with no additional hourly
charges (the "Flat-Rate Plan"). Subscribers can also choose to prepay for one
year in advance at the monthly rate of $17.95.
* An alternative offering three hours for $4.95 per month, with additional
time priced at $2.50 per hour.
* An alternative offering of $9.95 per month for unlimited use - for those
subscribers who already have an Internet connection and use this connection to
access AOL.
In July 1997, the Company introduced premium games services, for which
members pay $1.99 per hour (after any free hours offered under promotional
programs) in addition to the regular monthly membership fee and hourly usage
charges as set forth above.
The Company announced on February 9, 1998, that it will increase the price
of its Flat-Rate Plan for the AOL service by $2.00 per month to $21.95 per
month, in order to fund continued improvement of members' online experience and
to keep pace with the cost of members' increased usage. The price increase will
become effective at the start of each members' monthly billing cycle in April
1998. In addition, members may choose to pay for one year in advance at the
monthly rate of $19.95, a $2.00 per month increase from the previous annual plan
rate. Those subscribers who are currently on the annual plan will not be
subject to an increase until their renewal date. The Company will continue to
offer its other pricing plans with no changes.
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. This
plan was discontinued upon the availability of the Flat-Rate Plan on December 1,
1996.
As a result of the introduction of the Flat-Rate Plan as detailed above,
the Company's Internet service, Global Network Navigator ("GNN"), was
discontinued. The Company had launched GNN in October 1995.
Subsequent to the introduction of the Flat-Rate Plan, the Company
experienced a significant increase in average monthly subscriber usage, and an
attendant decrease in the average revenue per member-hour. The Company also
experienced higher cost of revenues relative to total revenues. The Company
plans to minimize the impact of the aforementioned changes by growing
advertising, commerce and other revenues as well as pricing actions and by
decreasing costs, on a relative basis (either on a per-hour basis or as a
percentage of total revenues), principally through network and operating cost
efficiencies.
An important component of the Company's business strategy is an increasing
reliance on advertising, electronic commerce and other revenues, which include
the sale of merchandise, advertising and related revenues, and transaction fees
associated with electronic commerce. Another important factor in the Company's
business strategy is the further reduction of the costs of operating the
Company's data network, on a per-hour basis, through the continuing build-out
and efficient traffic management of AOLnet, the Company's TCP/IP network. The
Company anticipates marketing expenses as a percentage of revenues to be lower
in fiscal 1998 than they were in fiscal 1997, primarily as a result of the
improved value proposition offered by flat-rate pricing, which is expected to
provide improved subscriber acquisition and retention rates, as compared to
rates achieved prior to flat-rate pricing. However, with the recently announced
$2.00 per month price increase for the standard monthly membership fee, the
Company may have to spend more on marketing, advertising and customer service
than in recent quarters in order to acquire and retain customers and combat
potential competitive pressures and responses. The Company's marketing strategy
is expected to continue to emphasize brand advertising as well as cost-effective
bundling agreements, whereby the Company's product is widely distributed with
new personal computers, the Windows operating system and other peripheral
computer equipment, and the Company will continue to market its products via
direct mail programs.
The growth of advertising, commerce and other revenues is important to the
Company's business objectives, as those revenues provide an important
contribution to the Company's operating results. In the second quarter of
fiscal 1998, advertising, commerce and other revenues totaled $108.8 million, an
increase of $50.6 million, or 87% over the comparable quarter in fiscal 1997.
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 more
revenues are generated from sources other than online service revenues, such as
advertising and electronic commerce. The Company expects that the growth in
advertising, commerce and other revenues, assuming such growth continues, will
provide the Company with the opportunity and flexibility to fund the costs
associated with the increased usage resulting from flat-rate pricing as well as
programs designed to grow the subscriber base and meet other business
objectives. Advertising, commerce and other revenues are generated primarily
from electronic commerce and advertising, and include the sale of merchandise by
the Company (principally computer hardware and software and AOL merchandise), as
well as fees received from the sale of advertising and fees received from
companies who market their products through the AOL service. Advertising
revenues are expected to grow in importance as the Company continues to leverage
its large, active and growing subscriber base. The Company is able to offer its
advertising partners a variety of customized programs, which may include
guaranteed numbers of impressions and select sponsorship of particular online
areas for designated time periods. In the past, electronic commerce revenues
earned from companies which marketed their products on the AOL service were
generally commission-based. In the future, the Company anticipates that a
higher proportion of these types of revenues will be derived from fixed fees
charged to these merchants, rather than being based solely on transaction
volumes. As merchants realize the value of reaching the Company's large and
active subscriber base, the Company expects to earn additional revenues by
offering selected merchants exclusive rights to market their particular class of
goods or services within the Company's online service.
The Company's operating margin declined in fiscal 1997, driven by the
impact of the Company's switch to flat-rate pricing in December 1996 and a
concomitant dramatic increase in member usage. Average monthly subscriber usage
in the first quarter of fiscal 1997, the last quarter before the introduction of
flat-rate pricing, was approximately 7 hours. In the second quarter of fiscal
year 1998, average monthly subscriber usage had increased to approximately 21
hours, and reached 23 hours per month in January 1998. Due to the lack of
historical operating experience under a flat-rate pricing structure, the Company
is unable to predict whether usage will continue to trend upward, and, if so, at
what rate. The Company is also unable to predict the impact on subscriber usage
patterns that will occur as a result of the $2.00 per month price increase to
its Flat-Rate Plan which will be implemented in the fourth quarter of fiscal
1998. If current usage trends continue, further pressures on operating margins
may result. The impact of increased usage on operating margins, if it occurs,
could be offset, in whole or in part, by increases in advertising, commerce and
other revenues, increased data network operating efficiencies, reductions in
marketing and other operating expenses, pricing changes or other factors or
actions.
The Company competes in a rapidly changing marketplace with a wide range of
other companies in the communications, advertising, entertainment and
information, media, direct mail and commerce fields. Current competitors of the
Company for usage, subscribers and for advertising and electronic commerce
include not only Internet service providers and online services, (including the
Microsoft Network, Prodigy Services Company, and various national and local
Internet service providers, long distance and regional telephone and cable
companies, including, among others, AT&T Corp., MCI Communications Corporation
and various regional Bell operating companies), but also Web-based Internet
service providers using industry-standard browser and navigational software,
telephone companies who may offer competing services directly to their customers
as part of their telephone service and suppliers of operating systems who may
incorporate functional equivalents to the Company's services in their products.
The Company also competes for usage and advertising and electronic commerce
revenues with major Web sites operated by search services and other companies
such as Yahoo! Inc., Netscape Communications Corporation, CNET, Inc., Lycos,
Inc. and Excite, Inc., with global media companies such as newspapers, radio and
television stations and content providers, such as CBS Corporation, The Walt
Disney Company and Time Warner, Inc., and with direct marketing and
telemarketing companies.
The development of midband and broadband distribution technologies,
including cable Internet access services offered by @Home Network, Road Runner
Group (owned by Time Warner, Inc.) and MediaOne, Inc. (a subsidiary of US WEST
Media Group), advanced telephone-based access services offered through digital
subscriber line (DSL) technologies offered by local telecommunications companies
and other advanced digital services offered by broadcast and satellite
companies, is intensifying the competition to which the Company is subject.
Emerging convergent technologies offering combinations of television and
interactive computer services, such as those offered by WebTV and NetChannel,
offer yet an additional competitive alternative to the offerings of the Company.
Some of the present competitors and potential future competitors of the
Company may have greater financial, technical, marketing and/or personnel
resources than the Company. The competitive environment could (i) require price
reductions and increased spending on marketing, network capacity, content
procurement and product development, (ii) limit the Company's opportunities to
enter into and/or renew agreements with content providers and distribution
partners, (iii) limit its ability to develop new products and services, (iv)
limit its ability to continue to grow its subscriber base, (v) result in
increased attrition in the Company's subscriber base and (vi) negatively impact
the Company's ability to meet its business objective of changing its business
model into one in which more revenues and profits are generated from sources
other than online service subscription revenues, such as advertising and
electronic commerce. Any of the foregoing events could have an impact on
revenues or result in an increase in costs as a percentage of revenues, which
could have a material adverse effect on the Company's business, financial
condition and operating results.
Results of Operations
Online Service Revenues
For the three months ended December 31, 1997, online service revenues
increased from $351.2 million to $483.2 million, or 38%, over the three months
ended December 31, 1996. This increase was primarily attributable to a 37%
increase in the average number of AOL North American subscribers for the quarter
ended December 31, 1997, compared to the prior year comparable quarter, and a 3%
increase in the average monthly online service revenue per AOL North American
subscriber. The average monthly online service revenue per AOL North American
subscriber increased from $16.95 in the three months ended December 31, 1996 to
$17.43 in the three months ended December 31, 1997. This increase was
principally attributable to a reduction in the amount of refunds/credits issued
to subscribers in the quarter ended December 31, 1997.
For the six months ended December 31, 1997, online service revenues
increased from $662.4 million to $917.3 million, or 38%, over the six months
ended December 31, 1996. This increase was primarily attributable to a 38%
increase in the average number of AOL North American subscribers for the six
months ended December 31, 1997, compared to the prior year comparable period,
and a 3% increase in the average monthly online service revenue per AOL North
American subscriber. The average monthly online service revenue per AOL North
American subscriber increased from $16.90 in the six months ended December 31,
1996 to $17.40 in the six months ended December 31, 1997. This increase was
principally attributable to a reduction in the amount of refunds/credits issued
to subscribers in the six months ended December 31, 1997.
The Company is unable to predict the impact on online service revenues
resulting from the $2.00 per month price increase to be implemented on April 1.
The Company anticipates that the increase in online service revenues will be
partially offset by the loss of some number of subscribers and by some reduction
in the growth of new subscribers. The Company is unable to predict the amount
of such offset.
Advertising, Commerce and Other Revenues
For the three months ended December 31, 1997, advertising, commerce and
other revenues, which consist principally of the sale of merchandise,
advertising and related revenues, transaction fees associated with electronic
commerce and data network service revenues, increased from $58.2 million to
$108.8 million, or 87%, over the three months ended December 31, 1996. For the
six months ended December 31, 1997, advertising, commerce and other revenues
increased from $97.0 million to $196.3 million, or 102%, over the six months
ended December 31, 1996. The increase in both periods was driven primarily by
more advertising on the Company's online service and increases in the sale of
merchandise, primarily due to an expanded number of products offered for sale to
the Company's larger subscriber base. Advertising and electronic commerce
transaction fees increased by 181% and 234%, respectively, in the three and six
month periods ended December 31, 1997, from $18.7 million in the three months
ended December 31, 1996, to $52.5 million in the three months ended December 31,
1997, and from $28.8 million in the six months ended December 31, 1996 to $96.1
million in the six months ended December 31, 1997. Merchandise sales increased
by 28% and 32%, respectively, in the three and six month periods ended December
31, 1997, from $25.5 million in the three months ended December 31, 1996, to
$32.7 million in the three months ended December 31, 1997, and from $43.3
million in the six months ended December 31, 1996 to $57.3 million in the six
months ended December 31, 1997. At December 31, 1997, the Company's advertising
and electronic commerce backlog, representing the minimum contract value of
advertising and electronic commerce agreements signed, less revenues already
recognized from these agreements, was approximately $320 million, up from
approximately $16 million at December 31, 1996.
Commencing with the sale of ANS on January 31, 1998 (See Note 7 of Notes to
Consolidated Financial Statements), the Company will no longer report data
service revenues as a component of Advertising, Commerce and Other Revenues.
The Company is unable to predict the effect of the $2.00 per month price
increase on subscriber acquisition and retention rates. Any effect on
subscriber acquisition and retention rates may impact the rate of growth in
advertising, commerce and other revenues.
Cost of Revenues
Cost of revenues includes network-related costs, consisting primarily of
data network costs, personnel and related costs associated with operating the
data centers, data network and providing customer support and billing, host
computer and network equipment costs, the costs of merchandise sold, and
royalties paid to information and service providers. For the three months ended
December 31, 1997, cost of revenues increased from $261.9 million to $386.0
million, or 47%, over the three months ended December 31, 1996, and increased as
a percentage of total revenues from 64.0% to 65.2%. For the six months ended
December 31, 1997, cost of revenues increased from $463.0 million to $713.0
million, or 54%, over the six months ended December 31, 1996, and increased as a
percentage of total revenues from 61.0% to 64.0%.
The increase in cost of revenues for the three and six month periods ended
December 31, 1997 was primarily attributable to increases in data network costs,
host computer and network equipment costs and personnel and related costs
associated with operating the data centers, data network and providing customer
support and billing. Data network costs increased primarily as a result of the
larger customer base and more usage by customers. Host computer and network
equipment costs, consisting of lease, depreciation and maintenance expenses,
increased as a result of additional host computer and network equipment,
necessitated by the larger customer base and more usage by customers. Personnel
and related costs associated with operating the data centers, data network and
providing customer support and billing increased primarily as a result of the
requirements of supporting a larger data network, a larger customer base and
increased online service revenues.
The Company's contract with certain network providers allows for the
Company to be charged on the basis of actual costs incurred by the providers.
Actual cost information received from the network providers during the most
recent quarter indicates that the actual costs were lower than originally
anticipated and accrued for by the Company. As a result, management revised its
estimate of network access accruals during the quarter ended December 31, 1997,
resulting in an aggregate pre-tax benefit of approximately $17.3 million, which
related to periods prior to September 30, 1997. In addition, the Company
accumulated volume-based cash credits during the quarter of approximately $11.8
million under a contract with one of its network providers. These cash credits
will be recognized on a straight-line basis over the remaining term of the
contract.
The increase in cost of revenues as a percentage of total revenues for the
three and six month periods ended December 31, 1997 was primarily attributable
to increases in host computer and network equipment costs and data network
costs, partially offset by a decrease in royalties paid to information and
service providers.
Several factors influence the Company's cost of revenues as a percentage of
total revenues. These factors include the rates of subscriber acquisition and
retention, average subscriber usage, the growth of advertising, commerce and
other revenues, and other costs of delivering the service. Principally due to
the increase in average subscriber usage and the other factors noted, the
Company expects cost of revenues as a percentage of total revenues to be higher
in the future. The Company is unable to predict the impact on cost of revenues
as a percentage of total revenues which will result from the foregoing factors,
notwithstanding any increased revenues attributable to the $2.00 per month price
increase in its Flat-Rate Plan which will be implemented in the fourth quarter
of fiscal 1998.
The Company continues to build AOLnet, a TCP/IP data network, in order to
increase its network capacity, provide its members with higher speed access, and
reduce data network costs on a per hour basis. As the Company rapidly builds
AOLnet, it plans to continue to manage a high percentage of its total traffic to
this network and to negotiate more favorable pricing based on volume discounts,
which would lead to a lower overall data network per hour cost.
On January 31, 1998, the Company consummated a Purchase and Sale Agreement
pursuant to which it acquired the online services business of Compuserve
Corporation and approximately $175 million ($162 million in cash after purchase
price adjustments made at closing), from Worldcom, Inc. in exchange for ANS
Communications, Inc. Additionally, upon closing of the aforementioned
transaction, the Company entered into a five year network services agreement
with WorldCom which will provide the Company with significantly expanded network
capacity for the Company's online service at favorable prices, and higher speed
access as it becomes commercially available (refer to Note 7 of the Notes to
Consolidated Financial Statements). ANS is an important component of the
portfolio of suppliers which comprise AOLnet, and, under the network services
agreement with WorldCom, will continue to be so in the future. The network
services agreement with WorldCom is structured in such a manner that the Company
anticipates its network costs will be at a level no greater that the Company
would expect to incur if it continued to own ANS, thereby achieving a key
benefit of ownership without the potential risks associated with ownership.
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, 1997,
marketing expenses decreased from $151.8 million to $96.8 million, or 36%, over
the three months ended December 31, 1996, and decreased as a percentage of total
revenues from 37.1% to 16.4%. For the six months ended December 31, 1997,
marketing expenses decreased from $231.0 million to $194.6 million, or 16%, over
the six months ended December 31, 1996, and decreased as a percentage of total
revenues from 30.4% to 17.5%.
The decrease in marketing expenses for the three and six month periods
ended December 31, 1997, and such expenses as a percentage of total revenues,
was primarily attributable to decreases in subscriber acquisition costs. The
Company made a change in the first quarter of fiscal 1997 which resulted in
subscriber acquisition costs being expensed for periods subsequent to the first
quarter of fiscal 1997, versus being capitalized and amortized over twenty-four
months in the first quarter of fiscal 1997 and prior. As a result of the
aforementioned change in accounting estimate, the balance of deferred subscriber
acquisition costs as of September 30, 1996, totaling $385.2 million, was written
off. For additional information regarding this change, refer to Note 2 of the
Notes to Consolidated Financial Statements.
For the six months ended December 31, 1997, marketing expenses, before
capitalization and amortization, decreased from $302.0 million to $194.6
million, or 36%, over the six months ended December 31, 1996, and decreased as a
percentage of total revenues from 39.8% to 17.5%. The decrease in marketing
expenses for the six months ended December 31, 1997, before capitalization and
amortization, was primarily attributable to a decrease in subscriber acquisition
costs, offset in part by an increase in other general marketing expenses,
principally related to an increase in personnel costs. The decrease in
marketing expenses as a percentage of total revenues for the six months ended
December 31, 1997, before capitalization and amortization, was primarily
attributable to a decrease in subscriber acquisition costs.
Product Development
Product development costs include research and development expenses and
other product development costs. For the three months ended December 31, 1997,
product development costs increased from $19.8 million to $23.6 million, or 20%,
over the three months ended December 31, 1996, and decreased as a percentage of
total revenues from 4.8% to 4.0%. For the six months ended December 31, 1997,
product development costs increased from $38.3 million to $39.4 million, or 3%,
over the six months ended December 31, 1996, and decreased as a percentage of
total revenues from 5.0% to 3.5%. The increase in product development costs
was primarily due to a relatively flat level of personnel expense in the two
quarterly periods, which was impacted by terminations that took place in the
Company's second quarter fiscal 1997 restructuring, combined with a decrease in
the overall percentage of product development costs capitalized. The decrease
in product development costs as a percentage of total revenues was primarily a
result of the substantial growth in revenues.
General and Administrative
For the three months ended December 31, 1997, general and administrative
expenses increased from $29.2 million to $50.7 million, or 74%, over the three
months ended December 31, 1996, and increased as a percentage of total revenues
from 7.1% to 8.6%. For the six months ended December 31, 1997, general and
administrative expenses increased from $49.3 million to $105.0 million, or 113%,
over the six months ended December 31, 1996, and increased as a percentage of
total revenues from 6.5% to 9.4%. The increase in general and administrative
costs, and such costs as a percentage of total revenues, was primarily
attributable to higher personnel costs, which included compensatory stock option
and other charges related to the planned sale of ANS. In addition, there were
increases in professional fees, principally related to legal matters, as well as
facility related costs.
Amortization of Goodwill
Goodwill is being amortized on a straight-line basis over periods ranging
from two to ten years. Amortization of goodwill increased to $2.2 million in the
three months ended December 31, 1997 from $1.6 million in the three months ended
December 31, 1996. Amortization of goodwill increased to $3.8 million in the
six months ended December 31, 1997 from $3.5 million in the six months ended
December 31, 1996. The increase in amortization of goodwill in the three and
six month periods ended December 31, 1997 is primarily attributable to various
purchases of companies made by the Company subsequent to the second quarter of
fiscal 1997 partially offset by a decrease in goodwill associated with GNN,
which was written off in connection with the Company's fiscal 1997 restructuring
charge.
Restructuring Charge
In connection with a restructuring plan adopted in the second quarter of
fiscal 1997, the Company recorded a $48.6 million 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. As
of September 30, 1997, substantially all of the restructuring activities have
been completed and the Company reversed $1.3 million of the original
restructuring accrual.
Settlement Charge
In the quarter ended December 31, 1996, the Company recorded a charge of
$24.3 million related to a legal settlement reached with various State Attorneys
General to resolve potential claims arising out of the Company's introduction of
flat-rate pricing and its representation that it would provide unlimited access
to subscribers. Pursuant to this legal settlement, the Company agreed to make
payments to subscribers, according to their usage of the AOL service, who may
have been injured by their reliance on the Company's claim of unlimited access.
These payments do not represent refunds of online service revenues, but are
rather the compromise and settlement of allegations that the Company's
advertising of unlimited access under its flat-rate pricing plan violated
consumer protections laws. As of December 31, 1997, the Company revised its
estimate of the total settlement charge and reversed $1.0 million of the
original settlement accrual.
Other Income (Expense)
Other income (expense) consists primarily of investment income and non-
operating gains net of interest expense and non-operating charges. The Company
had other income of $0.7 million and other expense of $1.4 million in the three
months ended December 31, 1997 and 1996, respectively. The Company had other
income of $6.1 million and $1.1 million in the six months ended December 31,
1997 and 1996, respectively. The increases in other income for the three and
six month periods ended December 31, 1997, are primarily attributable to the
sale of certain available-for-sale securities and increases in net interest
income partially offset by decreases in the allocation of minority interest
losses and increases in non-operating losses related to various investments.
Provision for Income Taxes
The provision for income taxes was $13.7 million and $0 in the three months
ended December 31, 1997 and 1996, respectively, and $26.2 million and $0 in the
six months ended December 31, 1997 and 1996, respectively. For additional
information regarding income taxes, refer to Note 3 of the Notes to Consolidated
Financial Statements.
Net Income (Loss)
Net income was $20.8 million in the three months ended December 31, 1997
compared to a net loss of $129.1 million in the three months ended December 31,
1996. The net loss in the three months ended December 31, 1996 included $48.6
million for a restructuring charge and $24.3 million for a legal settlement.
Net income was $39.9 million in the six months ended December 31, 1997 compared
to a net loss of $482.8 million in the six months ended December 31, 1996. The
net loss in the six months ended December 31, 1996 included the aforementioned
restructuring charge and legal settlement as well as $385.2 million for the
write-off of deferred subscriber acquisition costs.
Liquidity and Capital Resources
The Company has financed its operations through cash generated from
operations, the sale of its capital stock and the issuance and sale of
convertible notes. The Company has financed its investments in facilities and
telecommunications equipment principally through leasing. Net cash provided by
operating activities was $154.2 million and $27.4 million in the six months
ended December 31, 1997 and 1996, respectively. Included in operating
activities were expenditures for deferred subscriber acquisition costs of $130.2
million in the six months ended December 31, 1996. Net cash used in investing
activities was $182.7 million and $51.5 million in the six months ended December
31, 1997 and 1996, respectively. Included in investing activities for the six
months ended December 31, 1997 was $153.3 million for the purchase of property
and equipment. Net cash provided by financing activities was $422.3 million and
$35.9 million in the six months ended December 31, 1997 and 1996, respectively.
Included in financing activities for the six months ended December 31, 1997 were
$342.1 million in proceeds from convertible notes issued and sold in November
1997 (see below), $28.5 million in proceeds from notes payable, and $51.0
million in proceeds from the sale of common stock pursuant to employee stock
option and purchase plans. At December 31, 1997, the Company had working
capital of $139.9 million, compared to a working capital deficiency of $231.0
million at June 30, 1997. The improvement in working capital was primarily
related to $342.1 million in net proceeds from convertible notes issued in
November 1997.
On November 17, 1997, the Company sold $350 million of 4% Convertible
Subordinated Notes due November 15, 2002 (the "Notes"). The Notes are
convertible into the Company's common stock at a conversion rate of 9.5797
shares of common stock for each $1,000 principal amount of the notes (equivalent
to a conversion price of $104.3875 per share), subject to adjustment in certain
events. Interest on the Notes is payable semiannually on May 15 and November 15
of each year, commencing on May 15, 1998. The Notes may be redeemed at the
option of the Company on or after November 14, 2000, in whole or in part, at the
redemption prices set forth in the Notes. For additional information regarding
the Notes, refer to Part II, Item 2.
On January 31, 1998, the Company consummated a Purchase and Sale Agreement
(the "Purchase and Sale") by and among the Company, ANS Communications, Inc.
("ANS"), a then wholly-owned subsidiary of the Company, and WorldCom, Inc.
("WorldCom") pursuant to which the Company transferred to WorldCom all of the
issued and outstanding capital stock of ANS in exchange for $175 million ($162
million in cash after purchase price adjustments made at closing), and the
online services business of Compuserve Corporation, which was acquired by
WorldCom shortly before the consummation of the Purchase and Sale. Immediately
after the consummation of the Purchase and Sale the Company's European partner,
Bertelsmann AG, paid $75 million to the Company for a 50% interest in a newly
created joint venture to operate the CompuServe European online service. Each
company invested an additional $25 million in cash in this joint venture. The
Company generated approximately $212 million in cash as a result of the
aforementioned transactions. Concurrently with the Purchase and Sale the
Company also entered into a five year network services agreement with WorldCom
which provides the Company with significantly expanded network capacity for the
Company's online service at favorable prices, comparable to those expected to be
paid as a network owner/operator. In connection with these transactions, the
Company expects to realize a gain of $350 million to $400 million, which will be
recognized on a straight-line basis as a reduction of cost of revenues over the
five-year term of the network services agreement with WorldCom.
The Company enters into multiple-year data communications agreements in
order to support AOLnet. In connection with those agreements, the Company may
commit to purchase certain minimum data communications services. Should the
Company not require the delivery of such minimums, the Company's per hour data
communications costs may increase.
In May 1996, the Company entered into a joint venture with Mitsui & Co.,
("Mitsui") and Nihon Keizai Shimbun, Inc. ("Nikkei") to offer interactive online
services in Japan. In connection with the agreement, the Company received
approximately $28 million through the sale of convertible preferred stock to
Mitsui. The preferred stock has an aggregate liquidation preference of
approximately $28 million 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 data center capacity. The buildout of AOLnet
and the expansion of data center capacity requires a substantial investment in
telecommunications and server equipment, as well as facilities. The Company
plans to continue making significant investments in these areas. The Company
plans to fund these investments, which are anticipated to be between $500
million and $600 million in fiscal 1998, through a combination of leases, debt
financing and cash purchases.
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 to continue to invest in subscriber acquisition,
retention and brand 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.
Seasonality
The growth in subscriber acquisitions and usage appears 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 and following the holiday season,
when new computer and software owners are discovering Internet online services
while spending more time indoors due to winter weather. However, because of the
Company's limited history with the Flat-Rate Plan (which was adopted effective
as of December 1, 1996), the Company does not know whether such increases in
subscriber acquisitions and usage are primarily attributable to seasonal factors
or to increased demand for Internet online services as a result of the growing
market demand and utility for such services.
Beginning with the second quarter of fiscal 1998, the Company believes it
has begun to see the effects of seasonality in securing advertising commitments.
The Company expects that advertising commitments will be highest in the second
fiscal quarter each year due to calendar-year budgeting cycles of many
advertisers. However, because of the Company's recent focus on developing
advertising revenues, the Company does not know whether increases in securing
advertising commitments are due to seasonal factors or to increased interest by
advertisers in the Company's medium and distribution channels or other factors.
Revenue from all such advertising commitments generally is recognized over the
term of the particular contract in accordance with the terms of the contract and
applicable accounting rules. The Company expects that seasonality in member
acquisitions, usage and advertising commitments may continue to have an effect
in the future.
Year 2000 Compliance
The Company utilizes a significant number of computer software programs and
operating systems across its entire organization, including applications used in
operating the AOL Service, the Company's proprietary software, member services,
network access, content providers, joint ventures and various administrative and
billing functions. To the extent the Company's software applications contain
source codes that are unable to appropriately interpret the upcoming calendar
year 2000, some level of modification, or even possibly replacement of such
applications, may be necessary. The Company has appointed a Year 2000 Task Force
to perform an audit to assess the scope of the Company's risks and bring its
applications into compliance. This Task Force is currently in the process of
completing its identification of applications that are not Year 2000 compliant.
In addition, the Company has begun to ask its vendors, joint venture partners
and content partners about their progress in identifying and addressing problems
that their computer systems may face in correctly processing date information
related to the Year 2000.
The Company is in the early stages of conducting its Year 2000 audit and
therefore is unable to make a reasonable estimate of the costs associated with
Year 2000 compliance. Accordingly, no assurance can be given that any or all of
the Company's or third party systems are or will be Year 2000 compliant or that
the costs required to address the Year 2000 issue or that the impact of the
Company's failure to achieve substantial Year 2000 compliance will not have a
material adverse effect on the Company's business, financial condition or
results of operations.
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 oral or written 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 attrition in the Company's subscriber base and a
negative impact on the Company's ability to meet its business objective of
changing its business model into one in which more revenues are generated from
sources other than online service subscription revenues, such as advertising and
electronic commerce.
Risk that past difficulties of the Company and its data communications
access providers in providing adequate server and network capacity will recur.
Risks associated with the Company's reliance on its three main network providers
to its TCP/IP network, AOLnet. Risks related to the buildout of AOLnet and the
expansion of server and network capacity: the risk that demand will not develop
for the capacity created; the risk that supply shortages for local exchange
carrier lines from local telephone companies could slow the buildout; and the
risk that the failure to obtain the necessary financing could slow or halt the
buildout.
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, service failures by third party network service
providers, 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 failure to increase revenues at a rate sufficient to offset the
increase in data communications costs resulting from increasing usage. Risks
and uncertainties associated with a recently announced price increase,
including: the risk that competitive offerings to the AOL service may become
more attractive to AOL members; the risk of decreased demand for the AOL
service; the risk of slowing or reversing subscriber growth or reducing
subscriber retention rates and the resulting impact on the Company's ability to
generate advertising revenues; and the risk that the Company may be required to
increase marketing expenses. The risk that gross and operating margins will
decrease as a result of a decrease in the rate of advertising, electronic
commerce and other revenue growth or an increase marketing expenses.
The Company's inability to manage its growth and to adapt its
administrative, operational and financial control systems to the needs of an
expanded and evolving entity; and the failure of management to anticipate,
respond to and manage changing business conditions.
The risk that because of seasonal and other factors, the Company is unable
to predict growth in usage, subscriber acquisitions and advertising commitments.
The failure of the Company to establish new relationships with electronic
commerce, advertising, marketing, technology and content providers or the loss
of a number of relationships with such providers or the risk of significantly
increased costs or decreased revenues needed, to maintain, or resulting from the
failure to maintain, such relationships, as the case may be.
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 the Company's management's attention from
other ongoing business concerns; and the making or incurring of any expenditures
and expenses, including, but not limited to, significant charges for in-process
research and development.
The ability of the Company to leverage its technological and other
competencies through the introduction of new products and services; and its
ability to develop, or achieve commercial acceptance for, these new products and
services. The failure to resolve issues concerning commercial activities via
the Internet, including security, reliability, cost, ease of use and access.
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 United States, 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, privacy and
potentially adverse tax consequences.
The Company's inability to offer its services through advanced distribution
technologies such as cable, satellite, broadcast and enhanced telephone
distribution and the inability to offer advanced services such as voice and full
motion video. The Company's ability to develop new technology or modify its
existing technology to keep pace with technological advances, and the pursuit of
these technological advances requiring substantial expenditures.
The effects of, and changes in legal or regulatory environment relating to
the interactive online services and Internet industry in the United States,
Europe, Japan or elsewhere, such as telecommunication regulation, access
charges, encryption standards, content regulation, consumer protection,
intellectual property, privacy, electronic commerce and taxation.
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 pending or future litigation, governmental
investigations, legal and administrative cases and proceedings (whether civil or
criminal), settlements, judgments and investigations, claims, and changes in
those matters, and developments or assertions by or against the Company relating
to intellectual property rights and intellectual property licenses.
The failure of the Company or its vendors, joint venture partners, content
partners and other third party systems to achieve substantial Year 2000
compliance. The failure to modify or replace software applications that contain
source codes that are unable to interpret the upcoming calendar year 2000.
The risk that the Company's stock price could be adversely affected as a
result of substantial sales by holders of restricted stock or stock options.
The risk that a takeover attempt by a third party would be more costly and
difficult because of the Company's stockholder rights plan and certain
provisions in the Company's Restated Certificate of Incorporation and Restated
By-Laws.
PART II. OTHER INFORMATION
Item 2. Changes in Securities and Use of Proceeds
On October 17, 1997, the Company acquired Extreme Fans, Inc. in exchange
for the issuance of 33,726 shares of Company Common Stock and $175,000 in cash.
The transaction was a private placement and exempt from registration pursuant to
Rule 506 of the Securities Act of 1933.
On November 17, 1997, the Company completed the sale of a new issue of
$350,000,000 aggregate principal amount of 4% Convertible Subordinated Notes due
November 15, 2002 (the "Notes"). The Notes were sold by the Company to Goldman,
Sachs & Co., BT Alex. Brown Incorporated, Lehman Brothers Inc. and Cowen &
Company, as initial purchasers (collectively, the "Initial Purchasers"), in an
unregistered private placement conducted pursuant to Section 4(2) of the
Securities Act of 1933, as amended (the "Securities Act"). The discount to the
Initial Purchasers was 2.50% of the $350,000,000 principal amount of the Notes
purchased (or an aggregate of $8,750,000).
The Company has been advised that the Initial Purchasers resold
$317,850,000 aggregate principal amount of the Notes in the United States to
"qualified institutional buyers" in reliance on Rule 144A under the Securities
Act. The Company has been advised that the Initial Purchasers resold the
remaining $32,150,000 aggregate principal amount of the Notes through their
respective international affiliates, as selling agents, outside the United
States to non-U.S. persons in reliance on Regulation S under the Securities Act.
The Notes are convertible, in whole or in part, into shares of Common Stock
of the Company at any time on or after the 90th day following the last issuance
of Notes and prior to the close of business on the maturity date, unless
previously redeemed or repurchased, at a conversion price of $104.3875 per share
(equivalent to a conversion rate of 9.5797 shares per $1,000 principal amount of
Notes), subject to adjustment in certain events. Interest on the Notes is
payable semiannually on May 15 and November 15 of each year, commencing on May
15, 1998. The Notes may be redeemed at the option of the Company on or after
November 15, 2000, in whole or in part, at the redemption prices set forth in
the Notes. The Notes are not entitled to any sinking fund, and the Notes are
general unsecured obligations subordinated in right of payment to all existing
and future Senior Debt (as defined in the Indenture in respect of the Notes) of
the Company and effectively subordinated in right of payment to all indebtedness
and other liabilities of the Company's subsidiaries.
Item 4. Submission of Matters to a Vote of Security Holders
The Company held an Annual Meeting of Stockholders on October 31, 1997 to
vote on the election of directors and the ratification of auditors. Following
are the results of such meeting:
<TABLE>
Number of Shares
Matter Voted On For Withheld
Election of Directors:
<S> <C> <C> <C>
General Alexander M. Haig, Jr. 90,226,773 227,820
Daniel F. Akerson 90,314,808 139,785
For Against Abstain
Ratification of Auditors 90,378,990 27,965 47,638
</TABLE>
Item 5. Other Information
On January 9, 1998, the Company acquired Personal Library Software, Inc., a
developer of information indexing and search technologies, in a transaction that
will be accounted for under the purchase method of accounting. The total
purchase price was approximately $15 million, comprised of approximately $9
million in stock and $6 million in assumed liabilities. In connection with this
transaction, the Company expects to record a charge for acquired in-process
research and development of approximately $9 million in the quarter ending March
31, 1998.
On January 31, 1998, the Company consummated a Purchase and Sale Agreement
(the "Purchase and Sale") by and among the Company, ANS Communications, Inc.
("ANS"), a then wholly-owned subsidiary of the Company, and WorldCom, Inc.
("WorldCom") pursuant to which the Company transferred to WorldCom all of the
issued and outstanding capital stock of ANS in exchange for $175 million ($162
million in cash after purchase price adjustments made at closing), and the
online services business of Compuserve Corporation, which was acquired by
WorldCom shortly before the consummation of the Purchase and Sale. Immediately
after the consummation of the Purchase and Sale the Company's European partner,
Bertelsmann AG, paid $75 million to the Company for a 50% interest in a newly
created joint venture to operate the CompuServe European online service. Each
company invested an additional $25 million in cash in this joint venture. The
Company generated approximately $212 million in cash as a result of the
aforementioned transactions. Concurrently with the Purchase and Sale the
Company also entered into a five year network services agreement with WorldCom
which provides the Company with significantly expanded network capacity for the
Company's online service at favorable prices, comparable to those expected to be
paid as a network owner/operator. In connection with these transactions, the
Company expects to realize a gain of $350 million to $400 million, which will be
recognized on a straight-line basis as a reduction of cost of revenues over the
five-year term of the network services agreement with WorldCom.
At December 31, 1997, ANS had assets of $101.1 million (including $1.1
million in intercompany receivables), liabilities of $55.6 million and
stockholder's equity of $45.5 million. The major components of assets were
$36.9 million in property and equipment and $31.3 million in goodwill. The major
component of liabilities was $46.9 million in other accrued expenses and
liabilities. For the quarter ended December 31, 1997, ANS' third party revenues
(excluding intercompany revenues) totaled $14.1 million and are included in
advertising, commerce and other revenues in the Consolidated Statements of
Operations.
On February 6, 1998, the Company's stockholders approved an amendment to
the Company's Restated Certificate of Incorporation to increase the authorized
number of shares of common stock from 300,000,000 to 600,000,000.
The Company announced on February 9, 1998, that it will increase the price
of its Flat-Rate Plan for the AOL service by $2.00 per month to $21.95 per
month, in order to fund continued improvement of members' online experience and
to keep pace with the cost of members' increased usage. The price increase will
become effective at the start of each members' monthly billing cycle in April
1998. In addition, members may choose to pay for one year in advance at the
monthly rate of $19.95, a $2.00 per month increase from the previous annual plan
rate. Those subscribers who are currently on the annual plan will not be
subject to an increase until their renewal date. The Company will continue to
offer its other pricing plans with no changes.
Also on February 9, 1998, the Company announced a series of organizational
and management changes, including: organizing the Company's operations into
three brand groups supported by certain common infrastructure services; and
forming AOL Investments to manage the Company's investment portfolio. In
connection with the Company's reorganization into three brand groups, the
Company expects to incur a restructuring charge not to exceed $25 million in the
quarter ending March 31, 1998. Principal items expected to be included in the
charge are severance and related benefits for staff reductions, lease and
contract terminations, and other costs.
On February 10, 1998, the Company's Board of Directors approved a two-for-
one common stock split, to be effected by dividending one additional share for
each share owned on the record date, February 23, 1998. The payment date for
the stock split is March 16, 1998. The impact of the stock split is not
reflected in the accompanying financial statements.
Beginning with the three months ending March 31, 1998, the Company will
change its method of accounting for income taxes. Prior to January 1, 1998, the
Company followed the practice of computing its tax provision on the assumption
that stock option deductions were used first to offset its financial statement
income, providing a charge in lieu of tax and crediting the resulting benefit to
stockholders' equity. The Company will change its accounting for income taxes
to consider temporary differences and net operating loss carryforwards
determined before stock option deduction before recognizing tax benefits from
stock option deductions. Based on the information available, the Company's
provision for income taxes for the six months ended December 31, 1997 would be
substantially eliminated due to the change in accounting for income taxes being
retroactive to July 1, 1997.
Item 6. Exhibits and Reports on Form 8-K
(b) Reports on Form 8-K
Form Item # Description Filing Date
Form 8-K 5, 7 Press Release Announcing the Sale of $350 November 12, 1997
Million Subordinated Convertible
Debentures
Form 8-K 7, 9 Completion of the Sale of $350 Million December 2, 1997
Subordinated Convertible Debentures
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 17, 1998 SIGNATURE:/s/Stephen M. Case
Stephen M. Case
Chief Executive Officer
DATE: February 17, 1998 SIGNATURE:/s/Lennert J. Leader
Lennert J. Leader
Chief Financial Officer
(Principal Financial and Accounting Officer)
<TABLE> <S> <C>
<ARTICLE> 5
<MULTIPLIER> 1000
<S> <C>
<PERIOD-TYPE> 6-MOS
<FISCAL-YEAR-END> JUN-30-1998
<PERIOD-END> DEC-31-1997
<CASH> 518,200
<SECURITIES> 236
<RECEIVABLES> 117,848
<ALLOWANCES> 0
<INVENTORY> 0
<CURRENT-ASSETS> 717,434
<PP&E> 427,370
<DEPRECIATION> (91,273)
<TOTAL-ASSETS> 1,383,161
<CURRENT-LIABILITIES> 577,508
<BONDS> 0
0
1
<COMMON> 1,042
<OTHER-SE> 304,514
<TOTAL-LIABILITY-AND-EQUITY> 1,383,161
<SALES> 1,113,634
<TOTAL-REVENUES> 1,113,634
<CGS> 712,987
<TOTAL-COSTS> 1,053,552
<OTHER-EXPENSES> 10,232
<LOSS-PROVISION> 0
<INTEREST-EXPENSE> 3,980
<INCOME-PRETAX> 66,150
<INCOME-TAX> 26,218
<INCOME-CONTINUING> 39,932
<DISCONTINUED> 0
<EXTRAORDINARY> 0
<CHANGES> 0
<NET-INCOME> 39,932
<EPS-PRIMARY> .39
<EPS-DILUTED> .33
</TABLE>
