Not so long ago, the advertising business was the undisputed Achilles' heel of Internet service providers. But now, it turns out the Internet business has two heels to worry about.

Once pushed to the side by greater concerns about the weakening Internet advertising market, subscription profitability has emerged in recent months as an equally knotty problem, one that is entangling Internet stalwarts like AOL Time Warner's ( AOL) America Online and EarthLink ( ELNK).

The ISPs are caught between a rock and a hard place. Demand for their cash cow -- dial-up Internet access via telephone lines -- is slowing down or even declining as subscribers move to high-speed access or cut-rate dial-up suppliers. But though the ISPs look to the high-speed, or broadband, Internet business for growth, that avenue is littered with hazards that make the cash flows of the next few years much less certain than those of the past. For starters, broadband is less profitable than dial-up for AOL and EarthLink, and the path to profitability is uncertain at best.

If that isn't discouraging enough, new research provided to indicates that subscribers to dial-up service, or narrowband, are hardly paragons of loyalty. The predicament of the narrowband incumbents makes 2003 a crucial year for Internet access subscription issues, one in which the odds for a revival at AOL, for instance, will become easier to handicap.

Boom Town

Certainly, AOL and EarthLink have to do something to catch the broadband wave. While the growth of AOL's narrowband subscriber population slows and EarthLink's dial-up base shrinks, broadband subscriber counts are booming. From March 31, 2002, to March 31, 2003, households getting high-speed Internet connections via cable TV will jump from 8.1 million to 12.2 million, estimates Bruce Leichtman, president of broadband research and consulting firm Leichtman Research Group. High-speed Internet customers over telcos' DSL technology will grow from 4.5 million to 6.6 million, he says.

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Yet only a fraction of the 6 million new broadband customers are signing up for the service through EarthLink or AOL. EarthLink says it will net 300,000 additional broadband customers at best in 2002, and the two services claim about 1.3 million broadband subscribers between them, or a little more than 10% of March's totals.

Unfortunately for AOL and EarthLink, because the wholesale costs of broadband connections haven't been driven down as far as dial-up costs, they'll make less money from these subscribers, for the foreseeable future. When Earthlink moves a subscriber from dial-up to broadband, gross profits sink from nearly $15 per month to below $7, according to company figures. AOL, too, acknowledges that the profits won't be there at first. In 2003, the monthly gross profit for an average AOL narrowband subscriber will be $10.72, according to Bear Stearns analyst Ray Katz; for a broadband AOL subscriber, AOL broadband will reap a gross profit of $5.75 per customer per month, estimates Katz.

To add insult to injury, AOL is going to have to work pretty hard to get these new subscribers in the first place. In theory, with its well-established brand as an Internet service provider, America Online has a headstart at recruiting these customers when they decide to trade up to a broadband connection. But earlier this month, the company told analysts that only 9% of AOL subscribers -- not 9% of Internet users, but 9% of AOL subscribers -- are aware that the company offers a broadband version of its service. The company told analysts earlier this month that its goal is to retain a third of the people who drop narrowband service for broadband in 2003.

But new research from Leichtman hints at the difficulty AOL and other ISPs will have in retaining narrowband customers as they move to broadband. Surveying 1,250 households in areas where cable TV is available, Leichtman asked people interested in a broadband Internet connection who they would choose to get broadband service from. Thirty-four percent would pick their cable company, and 21% would pick a phone company, says Leichtman. Only 7% chose their current ISP. Among AOL subscribers, says Leichtman, the numbers were somewhat more encouraging, with 15% of current subscribers indicating they would stay with AOL for broadband.

Though the numbers hint that plenty of narrowband customers have yet to make up their minds, Leichtman says he's struck by how few respondents single out their current supplier. "There isn't a great deal of loyalty to narrowband ISPs," Leichtman says. "That represents a very large challenge.

So what are these publicly traded players going to do in 2003? First, they'll defend their soft underbelly against incursions by discount dial-up ISPs, chiefly $9.95-a-month discounter United Online ( UNTD). EarthLink, which bought PeoplePC earlier this year, is expected to roll it out as a discount brand next year, and AOL said in December it was considering its own discount brand.

Nudge, Nudge

Addressing broadband economics, EarthLink is focusing mostly on costs, telling Wall Street it expects to nudge gross profit per broadband sub toward narrowband levels. AOL, on top of a forthcoming marketing push to increase broadband awareness, will steer people toward its $14.95-a-month "bring-your-own-access" plan, betting that people will access the Internet from a cable operator or telco, but pay extra for admission to AOL's so-called "walled garden."

The economics of BYOA are certainly appealing to AOL, which Katz calculates would reap an $11.95 gross profit per member per month, 11% higher than the figure for narrowband subscribers.

Less certain is whether the economics will appeal to consumers, who have been loath to pay extra for Internet content and services once they've gotten access. In fact, a recent survey of 1000 AOL subscribers, J.P. Morgan found that 46% of them were unwilling to pay more for AOL-brand broadband than they would for generic broadband service. Thus, concludes analyst Spencer Wang, AOL has to improve the perceived value of the AOL service. Time may be on AOL's side, says Wang; given the current price of high-speed Internet service, only 7% of responding AOL subscribers are interested in broadband at all.

So here's the game plan for AOL: First, publicize your broadband service. Second, make it appealing. And third, good luck. You'll need it.

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