EarthLink to shun DSL for cable

But there's a catch. In an ironic twist, EarthLink is going head-to-head with its chief Internet service provider rival, America Online, on its home turf--AOL Time Warner's cable networks.

"You will see a significant percent of new subscribers on cable," said EarthLink Chief Executive Garry Betty on the company's third-quarter conference call Tuesday. "If a customer calls and is not specific, we will lead with cable where it's available because of its economic benefit to us."

As a condition of the AOL-Time Warner merger, the Federal Trade Commission required AOL Time Warner to let a rival, such as EarthLink, offer high-speed services over its cable networks.

Before the union, AOL had lobbied heavily for regulators to force the cable industry to open cable lines to competitors. Now the regulations could result in its biggest competitive threat.

EarthLink made it clear in its conference call meeting Tuesday that it plans to take full advantage of AOL Time Warner's cable network in another slight to DSL service. Most of EarthLink's broadband customers to date use DSL services, but executives prefer cable access because it has better profit margins--a measure that indicates a company's ability to turn sales into profit.

The EarthLink announcement came a day after SBC Communications said it will delay DSL launches in some areas because of regulatory hurdles and increased costs. Other DSL providers, such as Covad Communications, NorthPoint Communications and Rhythms Links, have filed for bankruptcy.

On Tuesday, EarthLink said it narrowed its losses and achieved cash-flow profitability a quarter ahead of predictions. The company's pro forma loss, which excludes merger-related costs and other items, narrowed to $22.7 million, or 17 cents a share, from $41.3 million, or 33 cents a share, a year ago. First Call had predicted the company would lose 19 cents a share.

EarthLink shares closed at $14.85 Tuesday, down $2.51, or 14 percent.

The strategy
EarthLink said its high-speed Internet access will be available to half the homes receiving Time Warner cable by the end of the year. In September it started offering its services over the cable networks in Columbus, Ohio, and Syracuse, N.Y.

EarthLink has 406,000 broadband subscribers, including the 60,000 customers it added in the third quarter. Most of these customers use DSL. The company said its total subscriber base for 2001 would be 4.8 million, below some analysts' estimates.

"It's too early to tell for sure what kind of progress they're making," said CIBC World Markets analyst John Corcoran. Neither EarthLink nor AOL Time Warner would comment on their cable businesses in recent quarterly conference calls. But "it's a huge focus for them going forward, and they have a strong management team," Corcoran said.

The company does face a formidable foe: AOL. The company is a "menacing obstacle," especially given its brand reputation and ties to its parent cable company, AOL Time Warner, said Rob Lancaster, an analyst from The Yankee Group.

Lancaster said EarthLink has a disadvantage since the marketing burden is on it. In its advertising, Time Warner's cable units offer very little mention of alternatives to the incumbent Roadrunner cable Internet access service, something which ISPs have complained about in the past.

Indeed, EarthLink said it will boost its marketing expenses to push cable access beginning in November. Betty declined to say how much the company is increasing its marketing expenses for the current quarter, but did say there will be "increased sales and market expenses, particularly in broadband." The company also noted in its quarterly report that "some of the benefits of this marketing spending will not be felt until the first quarter of 2002."

"EarthLink is in a good position regardless," added Lancaster, who said the company is approaching the issue the only way it can: by going head-to-head with the "formidable competition."

"They can compete by offering better service; that's part of their trademark," said CIBC's Corcoran, who said the company's signature "real and live" Internet services should translate well to cable. "They sell pure access of the Internet. It's not cluttered up like AOL, which wants to keep people in their 'walled garden,'" he said, referring to AOL's penchant for keeping users on its own properties.

The recent bankruptcy of broadband Internet provider Excite@Home will also help EarthLink progress with its cable business, Betty said. "It will be a stimulus toward bringing us closer together and having an open-access agreement with other cable companies out there," he said.

A slow payoff: Profit margins
The move toward cable is a significant shift for the company, which has considered DSL its broadband meal ticket, but Betty said the move makes good economic sense.

Analysts say operating margins excluding sales and marketing expenses for cable broadband subscribers are somewhere above 5 percent, whereas DSL is break-even at best. EarthLink's dial-up subscribers, however, are still more profitable with margins of around 65 percent.

Despite the optimism about cable, EarthLink isn't going to see an immediate payoff.

EarthLink said its subscriber growth slowed in the third quarter and predicted the situation could get worse in the fourth quarter.

A slowing economy may mean more customers will stick with their dial-up connections instead of migrating to the more expensive high-speed services.

"The upsell from narrowband to broadband could slow," said Corcoran. "People will keep Internet access, but they'll stay with narrowband."

In the short term at least, EarthLink can benefit from the slower migration to broadband access. Because dial-up customers provide more profits, Betty said the company's margins will improve. Toss in the company's recent rate increase from $19.95 to $21.95 a month and the "average revenue per user is expected to increase in the current quarter," Chief Financial Officer Lee Adrean said on the conference call.

The company said it expects revenue to be between $330 million and $335 million in the fourth quarter, and its net loss, before merger and acquisition related costs, to be between 8 and 11 cents a share. First Call predicted the company would lose 13 cents a share in its fourth quarter.

However, EarthLink, like other technology companies, is facing a wild card: the economy. Indeed, the company made some dour remarks about the situation.

"In light of softer economic conditions and expectations for weak holiday-season PC sales, we do not expect the normal seasonal strength in new Internet access sign-ups," the company said.