Microsoft shrugs off dial-up decline

Like America Online, Microsoft's MSN Internet service is feeling the pinch of competition from both high-speed and budget dial-up ISPs.

Microsoft on Tuesday reported that MSN in the first quarter witnessed a decline of 300,000 subscribers from the preceding quarter, leaving the second-largest Internet service provider with 8.7 million total subscribers. Company executives attributed the decline to further churn among subscribers who signed up for MSN as part of multiyear PC rebate programs with offline retailers such as Best Buy that have begun to expire.

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"We did see a slight decline in subscriber numbers primarily due to many subscribers coming off promotional deals that we had for many years. Those deals haven't been very profitable for us," said Lisa Gurry, group product manager at MSN. "So while some of those customers are churning off our service, we're actually seeing an increase in the profitability of our subscriber base."

The decline marks the second consecutive quarter of stalled growth for MSN despite the launch of a new version of the service last fall, coupled with a $300 million advertising campaign. In January, Microsoft said it would shift its focus to building out its "bring your own access" product, a package of MSN's Web services that it plans to sell to broadband users.

Microsoft is not alone in this predicament. Dial-up ISP leader AOL last quarter also witnessed its first subscriber decline in years. MSN, AOL and third-place ISP EarthLink are experiencing churn from their core of subscribers, who pay more then $20 a month for dial-up access.

"The market is mature, and the only growth in the ISP business is if you're a facilities broadband provider or if you're able to attract the new customers coming online, which are typically lower-end households," said Mark May, an equity analyst at Kaufman Bros.

Indeed, the largest discount ISP, United Online, has shown steady growth of its base of subscribers paying $9.95 a month. In the quarter ended Dec. 31, United Online reported 2.18 million subscribers, a net increase of 716,000 over the course of 12 months, including the 174,000 subscribers added from its BlueLight acquisition.

Meanwhile, a study in January showed that broadband Internet use in U.S. homes surged 59 percent in 2002, largely at the expense of dial-up ISPs, which witnessed a 10 percent decline during that year.

Half-empty or half-full?
While MSN's overall numbers are declining, the ISP maintains that the trend is not a bad sign. Rather, the company said the business remains healthy as it rids itself of lower-paying subscribers who ride on deals rather than pay full price--$21.95 a month--for MSN's Internet access.

"As opposed to AOL, which is really declining, I think MSN is churning out its low-paying customers," said David Card, an analyst at Jupiter Research. "I think that at some point, MSN will be affected by declining numbers of real customers due to broadband migration."

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Other aspects of the MSN business also showed positive signs. Microsoft reported that MSN's total revenue increased 26 percent from the preceding quarter to $508 million, much of which was fueled by a 55 percent growth in online advertising revenue. Analysts speculate that much of this revenue stems from its paid-search deal with Overture Services, which has infused tens of millions of dollars into the coffers of MSN and Yahoo for the past few quarters.

Meanwhile, MSN's subscription revenue, which includes businesses such as an enhanced Hotmail, increased 9 percent during the quarter.

"We will continue to operate our narrowband business as long as it's a viable business for us. Our focus is going to be improving profitability rather than gaining subscribers at any cost," MSN's Gurry said. "At this point, we are really focused on delivering the best software service to consumers, so we prefer to differentiate on quality of service rather than price."

Bowling for broadband
Nevertheless, the future of the Internet clearly hinges on the rapid penetration of broadband into U.S. homes. AOL and MSN have shifted their broadband ambitions by hyping what they've dubbed "bring your own access" services. The idea is to sell their respective services as add-ons for people using other broadband providers.

Dial-up ISPs have tried before to buy broadband access in bulk and then resell it as their own services. However, given the cost of buying broadband from phone companies, the margins for reselling high-speed access were slim when compared with dial-up. Bring-your-own-access deals would allow AOL and MSN to sell just their content or thier software for $14.95 and $9.95 a month, respectively.

AOL, MSN and Yahoo have all stated their confidence that cable and telephone companies will want to partner with them on bundled content and access services.

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So far, phone companies have taken steps, as evidenced by MSN's deals with Qwest Communications International and Verizon Communications, along with Yahoo's deal with SBC Communications.

Cable, on the other hand, is a different story. Companies such as Comcast and Time Warner Cable have spent hundreds of millions of dollars upgrading their systems to offer high-speed Net access. Not required by law to open their lines to other service providers, and stung by previous failures such as Excite@Home, cable companies have grown their broadband businesses without the help of AOL, MSN or Yahoo.

The question now is whether the access providers really need the help of those three Internet players to grow their broadband subscriber bases. Yahoo claims that its deal with SBC Communications has shown much benefit for both parties, but the company has not broken out what percentage of its SBC-Yahoo subscribers are new add-ons versus existing SBC digital subscriber line (DSL) customers who have migrated to the co-branded service.

Convincing Web users to pay an additional $9.95 to $14.95 a month on top of their hefty broadband bill will be a difficult sell.

"Content providers are trying to offer numerous bundles in test form, hoping that something is going to stick," said Youssef Squali, an equity analyst at First Albany. "While people are paying for extra storage and subscription content, people are not seeing the need to pay for these premium services on a mass basis."