What to Make of America Online's Hot Hand - Brief Article

Kiplinger's Personal Finance Magazine, March, 1999 by Brian P. Knestout

If Internet stocks were a high-stakes poker game, America Online would be holding a straight flush. Recently at $149 per share, the split-adjusted price of AOL stock is nearly triple the price it commanded when we last extolled its virtues (see "Great Stocks on Sale," Nov.). Last year, in fact, the price of a single share of AOL's stock rose an astounding 586%, and its market value leaped from $10 billion to $71 billion. Over the past five years, AOL's stock has returned 143% annually, making a $1,000 investment worth nearly $75,000 now.

Looking back at such numbers makes it easy to chide yourself for a lack of foresight. But crystal balls were in short supply five years ago, and still are. Current and prospective America Online investors need to ask themselves a serious question: How much further can this remarkable company play out its hand?

CASE FOR INVESTING. The surge in AOL's share price is part of the immense boom affecting Internet stocks in recent months. But AOL differs from most other Internet-related stocks because it is already profitable. In fact, three rivers of income flow into AOL's bay of profit: subscription charges, fees from businesses advertising their wares on AOL's Web sites, and electronic-commerce income.

Subscriptions are on a tear. The company has added subscribers at a record-setting clip, gaining a million new ones in the last six weeks of 1998 and boasting 15 million worldwide. Although subscriptions represent more than four-fifths of AOL's total income ($2.6 billion in fiscal 1998, which ended June 30), the mere addition of new users isn't whipping investors into a froth. What counts is what those users are doing online: reading ads, shopping, or both.

This is where AOL's recent $4.2-billion purchase of Netscape comes in. In the third quarter of last year, before buying Netscape, AOL took in $143 million in fees from online advertisers and businesses that made sales on AOL sites. Owning Netscape gives the company three additional sources of revenue: helping businesses set up sales sites on the Web or directly on AOL, selling Internet-browser software to businesses, and selling ads that appear directly on Netscape's own Netcenter "portal," or Internet entry point.

RISKS TO CONSIDER. Alas, nothing in America Online's hand, pat as it may seem, justifies buying its shares at $149 for anything other than the long, long term. For all its vaunted potential, AOL is expected to earn a mere 56 cents per share in fiscal 1999 and only 86 cents per share in 2000, which means it trades at a whopping 266 times 1999 earnings per share and 173 times 2000 earnings. Even if AOL's price remained flat--and even if it really did achieve the 47% rate of earnings growth being forecast by a consensus of analysts surveyed by Zacks Investment Research--six years would pass before the stock traded for less than 30 times its earnings per share. To put it another way, investors are buying AOL shares in 1999 in anticipation of earnings in the year 2005.

The wonder of it all is that every analyst Zacks surveys still says to buy America Online. Explains one buyer, manager Kevin Landis of Firsthand Technology Leaders fund: "For most people, the road to riches means owning the better company over a long period of time. If you're going to buy and hold, you won't look back on buying AOL as a bad decision."