Covad's BlueStar buy sends shares tumbling

One of the nation's largest high-speed Internet companies, Covad agreed to buy BlueStar for about $200 million in an all-stock deal.

Covad shares slipped nearly 29 percent to close at $ 18.06, well below the company's 52-week low. The company warned on a conference call with analysts that its digital subscriber line (DSL) installations might not reach earlier projections for 2000 and 2001, and the BlueStar acquisition could make Covad a competitor with its partners.

The acquisition of BlueStar, a Nashville, Tenn.-based Internet service provider serving small and mid-sized businesses in the Southeastern United States, is intended to expand Covad's network in so-called second-tier cities and smaller and rural markets.

After reaching most of the nation's largest metropolitan areas, Covad hopes to expand to fend off competition from rivals NorthPoint Communications and Rhythms NetConnections. It also looks to better compete with regional players targeting smaller markets, such as DSL.net, HarvardNet, New Edge Networks and Jato Communications, among others.

A wholesaler, Covad sells DSL lines to ISP partners that in turn resale them at retail prices to businesses and consumers. BlueStar, however, sells DSL directly to its customers, a strategy that some analysts believe Covad needed to adopt in order to control the billing and marketing relationship with its customers, rather than turning them over to its ISP partners.

"This acquisition is in line with our belief that Covad needed to acquire a retail sales strategy to continue its rapid expansion," Merrill Lynch analyst Ken Hoexter wrote in a research report. "We believe that this is the correct direction for the company as it will now be able to own end-user customers and benefit from up-sales of additional products and services."

But by selling directly to customers, the new strategy could pit Covad as competition against its partners. The company vows only to sell directly to customers in its smaller markets so as not to anger its large resale partners such as Concentric Network and Flashcom.

Covad also warned today that its installations will slow over the next two years because of the potential friction that could arise from its new direct sales model. Executives said, however, that expected revenues will match consensus estimates, according to analysts.

Merrill Lynch's Hoexter downgraded Covad stock to a near-term "accumulate" rating from a "buy." He noted that Merrill Lynch is "disturbed that Covad is also lowering DSL line installs by 18 percent for 2000 and 2001 to 245,000 and 620,000 from 300,000 and 760,000 respectively."

Covad offered 8 million shares to assume some debt for BlueStar, but the company could be required to issue another 5 million shares if certain performance goals are reached. BlueStar will cancel its planned initial public stock offering as a result of the sale. The deal is expected to close, pending standard regulatory approvals, within 90 to 120 days.

Last month, Covad was the subject of takeover rumors, due in part to its depressed stock price.

Covad was the third most active stock on the Nasdaq market today, with more than 37 million shares changing hands. Prior to today's low, Covad shares have traded as high as $66.63 and as low as $19.06 in the past year.