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Why Wall Street Is Dead Wrong About AOL

Ponder for a moment what AOL will be worth once Microsoft starts offering free Internet access.

With this column, we introduce Steve Sherman, an equity research analyst with Duff & Phelps Investment Management. Steve is a generalist with a specialty in the technology sector and is an avid follower of Internet stocks. As always, let us know what you think.

Merrill Lynch's Henry Blodget

reiterated his buy rating on

America Online


with a price target of 150 Wednesday, based on the premise that AOL will benefit from a great e-Christmas. It's hard to argue against Blodget's great track record, but this time he's not going to be right: Though a big e-Christmas will boost a lot of the net stocks, AOL will not be among them.

Why? In a story line that would make the


jealous, competition from



(which we are long in some of our accounts) is going to spoil AOL's Christmas, and show that it may be the most overvalued stock in the world.

This message will not be greeted with a chorus of cheers: Everyone on the street likes AOL, and the stock has been a big winner for a lot of people. But unlike the Net stocks -- a lot of which I think are great businesses with very attractive valuations -- AOL will lose you money, because owning AOL is a bet against Microsoft's greed.

We all know AOL is a great company. It has dominant market share in a fast-growing business, and it has sticky content that has kept the customer base growing through many competitive challenges. The difference this time is that Microsoft is about to make Internet access free. FREE.

That's a whole different ball game, one AOL isn't prepared to play. In the past, others have tried to compete with AOL primarily on quality and services, not price. In that environment, customers clearly chose AOL. There is no question people prefer AOL at a similar price: When the services cost about the same, MSN attracted 2 million users; AOL netted 18 million.

Now if you think

Bill Gates

is happy playing second fiddle to

Steve Case

and AOL, you don't know much about Microsoft. To be sure, Gates wants Microsoft's large share of any future net profits; but more importantly, Microsoft wants to protect its dominant PC operating system from potential Internet-based competition.

In the meantime, AOL is trying to push Microsoft around on the instant messenger business, creating an environment where Bill Gates and Microsoft President

Steve Ballmer

would get no small satisfaction from showing Steve Case who the big dog really is.

So Microsoft has the motive to make access free. With over $17 billion in cash, it clearly has the


to do so. The only missing ingredient is


. It wouldn't be prudent to launch such a massive competitive strike with the

Justice Department

trial under way. As the trial wraps up in the next few months, that window of opportunity is about to open wide.

Some will argue that just because Microsoft can offer free access doesn't mean they will. And yet the $400 rebate program that Microsoft initiated with


in June was a warning shot that should have sounded more alarms than it did. For those who didn't see the rebates as a precursor to free access, an Aug. 5 article in

The Wall Street Journal

quoted Brad Chase, Microsoft's point man on the new Internet strategy. "We intend to be aggressive with access," Chase said. "AOL might think about it as a profit center. That's not how we think about it."

To me, at least, the message is clear. Microsoft wants to own this market now and worry later about how to make money on it. It's one of the few companies in the world that can afford to do that.

Nor will AOL be likely to benefit from the two-tiered pricing model that will follow, in which 56k access will be free, and high-speed access will be charged at a premium.

Some argue that you can get free Internet access today, and it hasn't hurt AOL one bit. Why will this round be different? Because this is Microsoft, not Joe's Free ISP. When Microsoft makes home access at 56 kilobits-per-second free, it will be in your face every minute. It will be on TV, in the newspaper, the e-paper and on billboards. The ads will ask but a simple question: Why pay for AOL when you can get MSN for free? For those of you who are AOL customers, or know folks who are AOL customers, do your own survey. Would you continue to pay $21.95 a month if you knew you could get simple, reliable, free access from Microsoft? Most people will switch.

Don't expect AOL to take this lying down. It'll either slash prices or give out huge rebates to keep market share. Either way, AOL will not be making any profits on Internet access for long.

Nor will AOL be likely to benefit from the two-tiered pricing model that will follow, in which 56k access will be free, and high-speed access will be charged at a premium. That's because AOL's customer base will be the slowest to trade up to high-speed access because they are generally the least tech-savvy of the access customers. That's precisely why many of them chose AOL in the first place. By the time AOL customers are ready to trade up in a significant manner, DSL and cable may be very competitive, or even free, so it's hard to see how AOL could earn enough from high-speed access fees to support a free 56k-access market.

The question for investors is how to value AOL in this type of environment. Say for the sake of argument that AOL can still charge a minimal price for access, enough to cover its costs, and that it is also able to maintain its huge market share. Both of these assumptions are generous, but not egregiously so.

AOL has a lot of specialized content and e-commerce deals, so even if it isn't making money on access it will still be a multibillion-dollar company. But without the cash flow from subscriber fees, a more appropriate benchmark for valuing AOL becomes



. But there's a difference: Since AOL is a closed system, a large percentage of net users won't have access to the AOL content. I can get to Yahoo! from anywhere, but I can't get to AOL from work, and I can't get to AOL if I have access at home with someone else.

As a result, AOL has to trade at a discount to Yahoo!, a thought that will horrify any owner of AOL today. But if AOL can't make a profit on access, it's hard to argue for a higher valuation than the dominant e-content site. Since most people in the market don't think that Yahoo! is grossly undervalued, then you've got to address the $95 billion in market cap between Yahoo!'s $30 billion and AOL's $125 billion. The net result is simple: Owning AOL is a losing bet against the deep pockets and greed of Microsoft.

Instead of making that bet, why not just light your wallet on fire. Chances are you'll lose less.

TSC would like to know what you think. Will Microsoft offer free Internet access in the near future?

Absolutely -- it's the next logical step for them.

Foughedaboudit! They know it would be suicidal.

They'd love to -- but even Gates knows the cost is too high.

IF Microsoft offers free 56k access, is AOL lunch meat?

Absolutely! --


Steve Case.

No way! AOL will more than make up for it in broadband, e-commerce and advertising.

It's gonna hurt 'em, but AOL will find a way to come out on top.

Steve Sherman is an equity research analyst with Duff & Phelps Investment Management, a Chicago-based money management firm with about $15 billion of assets under management for institutions and taxable individuals. At time of publication, Duff & Phelps was long Microsoft, although holdings can change at any time. Under no circumstances does the information in this column represent a recommendation to buy or sell stocks. Steve appreciates your feedback at .