Network Effects

The real power of network effects kicks in on the revenue side, when AOL monetizes its customers. "If AOL has 1 customer, huge advertisers like Procter & Gamble aren't interested in spending money there," he says. "But if AOL has 1 million customers, then P&G takes notice. With 10 million customers, I guarantee you that P&G wants in. And when AOL has 20 million customers, P&G can't afford not be interested."

But it's not just about the total volume of customers. "Over time," Reamer continues, "AOL has greater and greater capacity to choose among its millions of customers and pull out those who are likely to be of the most interest to a particular advertiser. AOL can identify, say, men between the ages of 24 and 34 who are interested in some topic, and sell that list of people for an enormous amount of money to relevant advertisers. The bigger and smarter AOL gets, the greater its ability to monetize its customer base."

Crunch the numbers, and you'll find that's exactly how it has worked over the past few years. At the beginning of fiscal 1998, AOL managed to generate revenues of $18.99 per customer. At the beginning of fiscal 1999, that figure had risen to $21.20. By the third fiscal quarter, AOL was taking in $21.53 for each customer it had. Over the same period, its subscriber base had increased by 3.5 million members.

Put simply: Success breeds success. More revenues per customer, multiplied by more customers, equal serious growth. "Just think of what this will look like a couple years out," Reamer says, going to a whiteboard to graph the phenomenon. "You don't have to go too far out to say -- 'Whoa! That's a lot of money.' That's the beauty of this equation. The amount that AOL -- and Yahoo!, and Amazon.com, and eBay -- can monetize from each of its customers today probably pales in comparison to how it will be able to monetize those customers two years from now."

Then it becomes a question of the "X factor" -- just how much do costs go down, profits go up, and earnings increase? Is it 2 times, or 10 times, or 100 times? "Plenty of people think that it's going to be 2 times; plenty of people think it will be 100 times," says Reamer. "That's a legitimate debate, because we don't know. What we do know is that in this environment, profitability per customer goes like this." Reamer draws another right angle on the whiteboard. "That means that earnings and cash flow do the same exact thing."

Scott Reamer's path to Wall Street was not nearly as straight as the lines he had been drawing on his whiteboard. Reamer was born in upstate New York and attended Lafayette College, where he majored in chemical engineering. He'd already been accepted to graduate school, to work toward a doctorate in chemical engineering, when he decided to take a Wall Street internship with Prudential Securities. "At the time, I thought to myself, 'I'm going to grad school where I'll spend five or six years getting my PhD, and then I'll probably work for Exxon. I'll never have an opportunity to be on the floor of the New York Stock Exchange during trading hours. I've got to go for this."

That one summer got him hooked. "I'd studied engineering and mathematics during my entire college career, and I didn't know a lot about Wall Street," he says. "But I became more and more interested, until at the end of the internship I just said, 'I've got to do this. I want to do this.' So I got an interview and worked in the investment bank at Prudential Securities."

After 18 months in Prudential's investment-banking program, Reamer became an analyst, covering enterprise-software companies. The companies he tracked included Microsoft, PeopleSoft, Sybase, and Informix. That was the spring of 1995. That summer, Netscape had its now-legendary IPO, and Reamer's world changed again. "Netscape had an enormous impact on Microsoft," Reamer says. "Jamie Kiggen [the senior analyst he was working with] and I got interested in it. We didn't officially cover Netscape, but we watched it all the time. We had to know everything about it because it affected Microsoft. We also started covering AOL around then."

As the Internet became a bigger and bigger deal, Reamer and Kiggen had to choose: stick with enterprise software or devote themselves full-time to the Net. They chose the latter, and eventually moved from Prudential to Cowen and Co. It was the perfect launching pad for Reamer and Kiggen. On Wall Street, Cowen (now SG Cowen) is what's known as a "boutique investment firm." Unlike the giants -- Merrill Lynch, Goldman Sachs -- it doesn't cover all of the publicly traded economy. It focuses on just two main areas: health care and technology. The big Wall Street firms were covering the Internet on a piecemeal basis, through their software and telecommunications analysts. Cowen let Reamer and Kiggen establish a stand-alone Internet research division. As a result, in the summer of 1996, they became the first full-time Internet-only analysts on Wall Street.