AOL’s Growing Pains

It’s not always easy to tell when a mere public relations problem has transmogrified into a full-fledged corporate disaster. But when “Tonight Show” host Jay Leno takes to mocking your product, and competitors buy air time to ridicule you on Super Bowl Sunday, you can be pretty sure you’ve crossed the line.

Such is the predicament America Online finds itself in today after several long weeks in which bad news seemed to surface almost daily.

About 8 million people use AOL’s private network to chat, exchange e-mail, read news and gain access to the Internet and the World Wide Web--more subscribers than all of its rivals combined. But the company’s inability to cope with the soaring demand is threatening to turn this high-tech success story into a high-profile warning sign about the dangers of pursuing growth at any cost.

The troubles began in December when the company, responding to mounting competition from low-cost providers of Internet access, abruptly switched from an hourly pricing scheme to a flat rate of $19.95 a month for unlimited access. The change resulted in a huge influx of customers and a surge in demand: Average daily usage per AOL member has more than doubled, to 32 minutes this month from 14 minutes in September.

As it turned out, the company was wholly unprepared to accommodate the additional traffic. Members trying to log on are now regularly greeted with busy signals, and network outages have struck with alarming frequency. AOL Chief Executive Steve Case had to endure the embarrassment of publicly pleading with customers to use less of the service.

The problems have prompted a rash of lawsuits from customers who say they’re being denied the service they’ve paid for; state attorneys general are looking into the matter too. New York on Friday pledged to sue AOL for fraud this week if a settlement cannot be reached.

Taken in isolation, most observers agree that each piece of bad news poses little threat to the long-term prospects of the company. AOL did, after all, have more than $1 billion in sales last year, and it dwarfs nearly every other company in the Internet business.

The switch to flat-rate pricing, which was announced along with a major change in accounting practices, was widely lauded by analysts as a necessary move that would enable the firm to keep expanding its customer base and beat back challenges from the many companies offering flat-rate Internet access. On Friday, AOL’s stock closed at $36.75, well above its low of $22.375 back in October.

But as the troubles mounted last week, it became clear that the cumulative effect of the problem could have an impact far greater than the sum of its parts.

“There will be permanent consequences that will severely affect them if they don’t get their act together,” says Peter Krasilovsky, vice president of Arlen Communications, a new-media consulting company in Bethesda, Md.

AOL’s problems have become the tech talk of the nation. Disenchanted users gather to commiserate at newsgroups such as alt.america.online and alt.aolsucks. Leno joked last week that AOL users who developed a taste for online sex will have to go back to the more pedestrian phone sex.

“It’s really hip to hate AOL,” says Abhishek Gami, a vice president with Nesbitt Burns in Chicago who follows Internet service companies.

That sentiment offers a unique opportunity for competitors such as Microsoft Network and EarthLink Network to poach dissatisfied customers. AT&T;’s WorldNet service boasted that it had profited from AOL’s problems to the tune of about 450 new customers in a single week, and that’s certainly the philosophy behind CompuServe’s Super Bowl ad.

“The news coverage helps to validate our feelings,” says Daniel Janal, who runs an online marketing firm in the Bay Area and teaches Internet marketing at UC Berkeley’s extension program. “If I’m an inexperienced user and I can’t get onto the service, I think I’m an idiot. But when I pick up the newspaper and I see that hundreds of thousands of people are affected as well, then I ask myself, ‘Why am I using their service?’ ”

Even more worrisome, says Cowen & Co. managing director Jamie Kiggen, is that people might decide to hold off on going online at all as a result of the bad publicity.

AOL can ill afford a fall-off in subscriptions. While the company previously relied on hourly charges to make money, it will now be dependent on revenue from advertising to supplement those charges. And with competition fierce for a small pool of online ad dollars, the ones with the most eyeballs win.

“The pressure for them to increase their customer base is so intense that they’re willing to do just about anything,” says John Robb, a senior analyst with Forrester Research in Cambridge, Mass.

Robb theorizes that Case might be positioning the company to be bought out by Microsoft: “Then they could convert them all over to Microsoft technology lock, stock and barrel. It would also solve a lot of AOL’s problems. Then AOL could focus on content aggregation and community building, which is what they do best.”

That scenario seems a bit far-fetched--antitrust regulators, among others, might well look askance at such a deal--but the idea of AOL being acquired by, say, a telephone company has long been a subject of speculation. (The company’s current market capitalization is about $3.45 billion.)

AOL’s financial situation, indeed, is less than rock-solid: When the company changed its highly controversial practice of accounting for marketing expenses as capital investments, it took a charge that wiped out all the profit it had ever made. It’s unclear whether the company is currently profitable, and analysts say it isn’t eager to spend more than is absolutely necessary to cope with the capacity problem.

“They want to have just enough modems to get over the current crunch, but they don’t want to build excess capacity,” Krasilovsky says.

AOL says it has committed $350 million to add 150,000 modems to the 200,000 already in operation and will break ground for a new 180,000-square-foot data center in February. The company will also add 600 customer-support representatives over the next six months and sharply reduce the distribution of free trial disks.

While that may go a long way toward solving AOL’s connection problems by the summer--when good weather will reduce demand for online time anyway--analysts say more must be done to alleviate the current public relations crisis.

For starters, AOL should make it easier for customers to cancel their subscriptions, Gami says. The company requires members to quit the service by phone so that it gets a last chance to persuade them to stay--a tactic that works in one of five cases.

AOL should also offer refunds--in cash, not online credits--to customers who have paid for unlimited usage but have not been able to connect, Janal says. In addition, AOL employees should monitor postings on Internet newsgroups to defend the company and calm customers down, he says.

In the meantime, Gami suggests that AOL addicts consider signing up with an Internet service provider and then paying the “Bring-Your-Own-Access” rate of $9.95 a month to access AOL services via the less-congested Internet. That would allow customers to use practically unlimited quantities of AOL services at a total monthly cost of about $30.

In the long run, Krasilovsky predicts, AOL’s proprietary content--including publications, easy-to-use chat forums, travel services and programming such as the wildly popular Motley Fool investing forum--will win many customers back.

Indeed, once you can get on, AOL remains faster, friendlier and in many ways more useful than the chaotic offerings of the World Wide Web.

Says Krasilovsky: “A lot of people who are quitting AOL are going to be pretty shocked when they go online and don’t see their buddy lists or their stock portfolios or ready access to their favorite chat rooms.”

Times correspondent Karen Kaplan covers technology and telecommunications. She can be reached via e-mail at [email protected]

(BEGIN TEXT OF INFOBOX / INFOGRAPHIC)

Skyrocketing Subscriptions

The number of people subscribing to America Online has soared since the end of 1993, when the service reported having 302,000 customers. Today, the company has more than 8 million people hooked into its computer network. A look at the growth in AOL subscribers, millions:

June 1994: 0.800

December 1994: 1.60

June 1995: 2.70

December 1995: 4.50

June 1996: 6.00

December 1996: 7.00

January 1997: 8.00

Source: Jupiter Communications