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Commentary: DSL companies consolidate as markets tighten

Market setbacks experienced by DSL companies show that the communications sector is being affected by some of the same market dynamics that are influencing dot-coms.

Recent earnings disappointments from Covad Communications and Copper Mountain Networks and the consequent market setbacks experienced by these firms and related digital subscriber line (DSL) companies demonstrate that the communications sector is being affected by some of the same market dynamics that are influencing dot-com firms.

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Earnings offer further evidence of telecom downturn
Like dot-com firms, DSL companies have until recently been riding high on "new economy" market fervor. However, instead of the general e-business futures that dot-coms were relying on, DSL companies are riding the promise of high-speed connectivity to small sites and homes.

To fund the necessary infrastructure build outs, many DSL companies and their competitive local exchange carrier (CLEC) brethren have raised large amounts of capital through junk bonds and other corporate debt instruments--while losing money trying to build market share. Now, like the dot-coms, they are facing hard times as the market loses patience with companies that show no sign of making money.

Unlike most dot-coms, however, DSL companies and CLECs are legitimate acquisition targets for large telecom companies, because they do have infrastructure that the telecom companies can use in their competition with each other and cable companies. Therefore, users of these systems are more likely to find the service they depend on taken over rather than just going out of business as many dot-coms threaten to do. As the stock prices of these DSL providers drop, eventually they become a value proposition for larger players and get bought.

DSL service providers face several challenges. First, they must build out infrastructure and provision through any incumbent local providers to reach customers. Second, in the consumer marketplace, they must compete with cable companies, which have a huge lead in the number of consumers signed up for high-speed services. Finally, in the potentially much more lucrative business marketplace, DSL providers must beat incumbent telecom companies to the branding and pricing punch to win the small-office connectivity market.

DSL equipment providers must continue to simplify provisioning while driving down hardware prices to enable the DSL service providers. In the case of Copper Mountain, it is having trouble driving the market connections and leverage of its larger competitors, and is gradually being squeezed out of the market.

At present, consumer demand for high-speed service far exceeds supply, and both cable and DSL companies are working to roll out services neighborhood by neighborhood. In most areas, consumers do not have a choice, but rather should be happy to get any high-speed service, because many areas have yet to be reached at all.

Similarly, businesses are always eager to consider cheaper/faster alternatives to connect small sites such as branch offices or retail stores. Unfortunately, delivering DSL services across the wide geographies that many businesses require is very difficult with today's limited service availability constraints.

In the interim, Covad and several other DSL providers are relying on incremental revenue from Internet service providers (ISPs). These ISPs pay Covad and other DSL providers to provide Internet users with higher-speed services. Unfortunately, smaller ISPs are going through the same problems raising capital and paying their bills as the rest of the telecommunications and dot-com sectors. That is why Covad now expects to have to write off about $16 million in back bills owed by ISP customers.

The economics of this market are harder than most people realize. Both cable and DSL providers expect that they can drive economies of scale through broader deployment, while bundling increasingly value-added services over time to increase revenues, until they are profitable. But there is a limit to how much the average home will spend per month on high-speed digital services.

The best situation for users would be for both the DSL and cable companies to succeed and compete on price. However, both sets of companies are shortsighted. Wall Street's opinion of DSL companies--and telecommunications in general--is swinging pendulum-like to the negative. Cable companies have been through this pendulum swing numerous times, and are likely to go through another phase when they drive profitability by maximizing the number of users on a shared set of cable modems instead of upgrading capacities, leading to performance complaints and another Wall Street backlash.

In reality, neither industry is as good or as bad as these pendulum swings would indicate, leading to more consolidation opportunities for the larger players (e.g., big telecom companies) that may have fallen behind technically.

META Group analysts Val Sribar, Dale Kutnick, Peter Burris, David Cearley, William Zachmann, David Willis, and Jack Gold contributed to this article.

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