Investors disappointed in ISPs

Internet service providers have seen their stocks take a beating over the past several months as investors have become increasingly leery of the companies' ability to stay on track with profitability projections.

Stock prices for Netcom Online Communication Services (NETC), PSINet (PSIX), BBN (BBN), and EarthLink (ELNK) are all hovering around 52-week lows.

Netcom, which hit its 52-week high of 44-1/2 in June, fell to 9-1/2 a share at today's close, down 1/8 of a point. Others have seen even more abrupt drops.

PSINet is trading near its 52-week low of 6-3/4 a share. The ISP closed at 7-1/4 a share today, up 1/8 of a point from yesterday but still far below its trading price of around 14 a share in January.

EarthLink, which went public in January, has lost almost 20 percent of its market value in the past two days. The Southern California-based ISP has dropped below its IPO price of $13 a share, closing today at 10-11/16.

The problem, analysts say, is that these companies are failing to meet their goals for turning a profit. PSINet, for example, had projected that it would be in the black during the first half of this year, but is now saying it will hit that goal at the end of the year or beginning of 1998. This is the kind of unpleasant surprise that angers Wall Street analysts and brokers, who are basing their stock recommendations in part on these profitability forecasts.

PSINet and others are missing those forecasts because the cost of maintaining their network infrastructure has increased more than they expected. The industrywide move to flat-rate fees in particular has put new demands on ISP networks as more and more customers log on for longer amounts of time.

To keep customers satisfied and the press at bay, ISPs are spending considerable amounts on expanding their networks to handle more users, more reliably. And that means the companies aren't becoming profitable as quickly as expected.

"To regain investor confidence, they need to get costs under control," said Pacific Growth Equities analyst Stephen Franco. "For the most part, ISPs lose money for flat-fee contracts. They need to move customers to usage-based fees for businesses for dedicated lines."

BBN's situation is a good example. In its latest quarterly report in January, the company lost 48 cents a share, 4 cents more than Wall Street was expecting, according to First Call. The company attributed the expanding operating loss to continued investment in BBN Planet's network infrastructure, sales, and marketing.

Franco now predicts the company to break even in the quarter ending in September or the quarter ending in December, later than his original estimate of June 1997.

The problem is bringing in enough revenue to keep up with escalating costs. "It just is not possible to make money unless you have millions of subscribers," said Chicago-based Everen Securities analyst Anthony Blenk. "The only people that can make money are businesses like America Online (AOL) because they offer other services as well and make money on advertising and merchandising. They have other revenue beyond $20-a-month subscription fees."

Consumer customers will put up with glitches to keep prices low, but ISPs who have focused on businesses have more opportunity to charge higher prices, according to Franco.

Netcom proved this point in December when it announced that it would raise prices and revamp its business model to appeal to business customers instead of home users. AT&T (T) and Sprint have also said they are considering moving to a tiered pricing scheme to attract users willing to pay more for extra services. AT&T, for example, is talking about offering one-stop shopping for such services as long distance, local calling, cellular, paging, and Internet access.

For now, the challenge of standing out in the crowd of service providers is customer support. "The question is do they add enough value for customers to pay more," said Deustche Morgan Grenfell analyst Bill Gurley.

AOL is obviously staying in the consumer market but is boosting its revenue base by selling advertising and premium content services. That's why the company's stock price has still remained stable despite its well-publicized legal and service problems.

But for the ISPs that get the majority of their revenues from access fees alone, analysts say profitability is going to continue to be a challenge.

To gain investor confidence, these companies need to set a definite calendar of when they will become profitable and explain how they are going to make it happen. Then they must actually meet those goals, Franco said.

Can they do it while continuing to improve their networks? "That is the big question," Franco said.

Other analysts say these companies don't have to become profitable quickly as long as they provide a credible explanation of how they can be in the black eventually.

"Companies don't necessarily have to be profitable right now as they continue to expand their network," said Gurley.

But for the time being, stock prices for many of these outfits will remain under pressure as companies revise their profitability calendars and try to adjust analysts' expectations.