Building an ISP on the cheap?

For Mark Goldston, getting by on the cheap is a badge of honor and "commoditization" is terrific news.

The chief executive of United Online, which was created by NetZero's purchase of rival Juno, is on a minor roll. The online access company, which offers both free and pay services, yesterday announced a pro forma profit along with a 9.5 percent increase in paying customers.

Considering the dismal outlook for so much of the ISP market, Goldston, a hard-selling cheerleader for his United Online, can be excused for laying it on a little thick when he draws analogies with eBay.

His argument is that United Online's low operating costs give it the sort of "virtual operating leverage" that will be reflected on the bottom line as sales pick up. As broadband prices drop, Goldston also believes United Online, which charges a $9.95 monthly fee, will grow at the expense of higher-priced dial-up rivals such as Microsoft MSN, America Online and EarthLink.

It's an ambitious claim, but in the meantime, the company's enjoying 50 percent margins and the stock is trading above $10, compared with its 52-week low of $1.70.

CNET News.com recently talked with Goldston, the former president of LA Gear and a top marketer at Reebok, about his strategy as well as the future of pay and free services on the Internet.

Q: NetZero became synonymous with free Internet access. That didn't sustain the business. Is the concept of a free ISP completely dead?
A: We still are a free ISP. AOL runs, on its worst day, five times as many ads as a free ISP ever did. The irony is that we're the purest. We're the only pay ISP that doesn't pop banner ads at you while you're online. You couldn't start a free ISP now because the advertising market's not fertile enough.

So what's the future of free, advertising-supported services--kinds of free sites--on the Web?
I think the free services, ad supported and the like, will be adjunct services. They won't be core services. This happened in the cable industry in the 1970s, when the whole notion was they would charge advertisers for commercials. The problem was they were so fragmented that the rates they charged were low...they wound up charging consumers a monthly fee, plus you had advertising.

What about the psychology of the Internet user? People are used to the notion that if it's on the Web, it should therefore be free.
The notion is this: If it's on the Web, it should be free. But if companies can't make money, they won't exist. It's not the Peace Corps. If we really think we're worth it, they'll pay for it. We're not in business to provide "nice-to-have product." We're in business to make money.

"If we really think we're worth it, they'll pay for it. We're not in business to provide nice-to-have product. We're in business to make money."

What market research firm would tell you: "Start charging for tap water?" But if you told people that the only way you can get tap water is to pay for it, would they say no? At the end of the day, it's a question of how much is necessary and how much is nice to have. People who have a free thing feel they have a good thing. All their behavior shows that if you ask them to pay, it will be Armageddon. But this has happened in every consumer market, and it's not the case.

Yahoo's trying to add pay services, but it remains fundamentally a free site. What do you think about their chances?
Yahoo to me is an affinity type organization. There are lots people who like the brand and congregate there. If they provide some unique services, I think they will have less of a problem.

What's the No. 1 obstacle facing companies moving from free to subscription?
If you're going to a pay model, you better have something that's compelling...If you're going to be a me-too product, who needs you?

You still have people who use your service for free. How do you get them to move up to become paying customers?
It's similar to network television. We take 20 to 25 percent of our available advertising inventory and run NetZero Platinum or Juno Platinum advertising. The pitch is that you don't have to change your e-mail--and you can go to faster, non-advertising-oriented system. There's also radio and TV advertising.

What growth rate do you need to maintain to build a healthy business?
In the ISP world, most companies have not made money--and they've been charging $24 to $28. Meanwhile, we are profitable on an EBIDTA (earnings before interest, taxes, depreciation, and amortization) basis with no debt, no interest expense. In fact, we have interest income. And we have only 440 employees, while EarthLink has 7,000.

But you've also had several sequential quarters of decreasing advertising and commerce revenue. Do you see that trend extending out much longer into the next year?
Over 85 percent of our revenue comes from paying customers; a year ago about 60 percent of our revenue was from advertising. We have become a profitable company using the pay model. Our customer acquisition cost is $35 compared with $195 at AOL.
If the advertising market doesn't come back, it doesn't matter. If you told me that a year ago, we would have said we're in a heap of big trouble. Now that we're profitable, if the (advertising) market roars back, every bit of that will go to the profit line. We've gotten to the point where advertising is accretive. Our free business is almost to the point where it's gross margin breakeven. The amount of money that it costs to keep people online is almost being offset by advertising and the e-commerce that we generate.

Is the idea to continue to price under what's charged by AOL and EarthLink?

"If the advertising market doesn't come back, it doesn't matter. If you told me that a year ago, we would have said we're in a heap of big trouble."

That's our competitive advantage because we built the company to be a free access company. It was highly automated toward keeping costs down, so if we grew the business by 3 million paying subscriptions, we wouldn't have to add one single employee or additional capacity.
We have capacity to handle millions of new users without adding new cost. That's our operating leverage. And we will keep this price for the foreseeable future because it's highly competitive.

But why wouldn't you charge more if you could and still undercut your competitors' prices?
But think about how compelling it is. For less than ten bucks, you have high quality access...If you have a competitive price point and are building a brand...I don't want to mess it up.

You've got the deal with Comcast to include a broadband element in your mix. How many people have bought into the offering?
We announced last February that the beginning of June would be our target date. We haven't solicited yet. I've never been a huge proponent of broadband; it's too expensive. There's not sufficient content on broadband. Other than high income and early adopters, I don't think people care about "always on." Your tap water's always on, but you don't run it all day. To the degree people want broadband, we'll have a competitive offering.

At the time of the deal, you were quoted saying that United will earn about $4.20 to $4.40 per high-speed customer through the arrangement. Still sticking with that projection?
We didn't want to make a huge investment before and deter us from the road to profitability. Going this way, we will make as much as going in on dial-up. We structured the deal with Comcast--and others--so that the money is as good--or better--as it is with dial-up.

More broadly, AOL is running into trouble maintaining subscriber growth. But won't you all face the same sort of challenge?
I came out of the sneaker business, which hasn't had growth in 12 to 14 years. Yet Nike's market share has gone from 20 percent to 45 percent. We're in a market--ISP--that has been commoditized. We have about 2.5 percent market share. Let's assume that the market for dial-up is flat to very modest growth. If we have 2.5 percent share, that means 97 percent of the people in this country don't use our brand.

We will become more prominent in terms of stealing market share. This market will polarize. The guy at the top will have to find an incredible set of features to justify why subscribers should buy them rather than broadband or a $9.95 service.

Is it more expensive being an ISP than it was a couple of years ago?
It's infinitely cheaper because of the telecom costs. When I joined in 1999, our telecom costs were 45 cents an hour. Now, it's 12 to 12.5 cents an hour.

Do you think you've got something to prove after LA Gear and the Einstein Noah's Bagels chain?
There's been lot of misconceptions and misreporting, actually. When I left LA Gear in the middle of 1994, we were profitable. They went bankrupt four years later. Yet people write articles--that's like writing that Larry Bird was a terrible player when was with the Celtics. He wasn't; the Celtics became terrible after he left.
I left Noah's Bagels in November 1997, having built it up into the largest bagel chain in world. The company didn't go bankrupt until 2000. Yet people write that (I) was at those companies and they went bankrupt. But they don't look up the dates that I worked at those companies.