THE DAY AHEAD: Mergers may boost NetZero, but watch the business model

Tech Industry

Free Internet service provider NetZero has all the makings for a hot IPO. It bumped up its price range and has a big-name underwriter in Goldman Sachs. Toss in consolidation talk courtesy of the EarthLink-MindSpring marriage and NetZero may look good to a lot of investors.

NetZero (Nasdaq: NZRO) priced its 10 million share initial public offering at $16 after bumping up its price range to $14 to $16 on Thursday. Shares trade Friday.



NetZero: Fad or future?



The leap of faith necessary to buy into the NetZero story is huge, but the gap closed once EarthLink and MindSpring got engaged Thursday. Talk about good timing. The new EarthLink will be the second largest ISP and there's a big pack that wants to get larger quickly. America Online (NYSE: AOL) is clearly top dog.

Once the EarthLink deals closes, Microsoft Corp.'s (Nasdaq: MSFT) MSN will fall to third place by about a million subscribers, according to International Data Corp. AT&T Corp.'s (NYSE: T) WorldNet service will trail EarthLink by about 1.3 million subscribers or so. And there's a whole pack of ISPs looking to get bigger.

Now look at NetZero's user stats. In less than a year, NetZero added 1.68 million registered users as of Aug. 31. From July to August, users jumped by about 500,000 users.

We'd argue that the growth is to be expected -- the price is right. But if an acquiring party, say WorldNet, Juno Online (Nasdaq: JWEB) or even MSN, were to buy NetZero and convert half of those 1.68 million users to paying customers it could gain more subscribers. NetZero has eyeballs and that makes it valuable to companies ranging from portals (free Yahoo! Internet access?) to other ISPs. MSN looks doubtful as a buyer since it plans to up its price to $21.95 a month in a surprise move, but you never know.

The dreaded business model

If it weren't for the takeover prospects and eyeballs, NetZero would look much worse.

The business model is highly questionable and plans to cover costs with advertising are a myth.

NetZero claims it can charge higher ad rates because its users will look at more ads, but analysts are skeptical. How many advertisers can a user look at? AOL pelts users with ads, but still depends on subscriptions to turn a profit. Much to AOL's benefit, MSN plans to raise prices to boost gross margins.

According to regulatory filings, about 891,000 of NetZero's 1.68 million users in August accessed the service and were delivered over 1.15 billion advertising impressions. Given the number of users accessing the NetZero service, the company said it believes "a number of our users have Internet access accounts with our competitors."

Translation: NetZero is also a second string ISP and usage may be off-and-on. That means it will be hard to deliver the advertising goods.

Customers registering with NetZero complete a demographic profile. NetZero can then identify and track the online behavior of each user for better targeting.

However, NetZero should be able to target its ads better. So far "the majority of our revenues have been generated from untargeted banner advertising and start page referrals." NetZero is working on tracking online usage and introduced an ad feature called ZeroPort in August.

Supporters are pointing at the revenue growth. Revenue for the quarter ending June 30 jumped to $3.7 million from $781,000 for the quarter ending March 31. Losses, however, also ballooned. In the June quarter, NetZero reported a loss of $8.2 million, up from $5.1 million in the March quarter. As of June 30, NetZero's deficit was about $15.3 million.

Raising a ruckus

NetZero is hardly alone in driving down Internet service costs, but could be a key player in messing up ISP profit margins.

AltaVista, a leading portal and search engine, recently began offering a free Net access. And a host of PC makers are bundling Net access in with computers. There's also startups like Freei Networks offering free services.

Eventually, the freebie crowd could cause problems.

The concerns about free Net access have a few analysts worried about AOL's profit margins. AOL's $21.95 a month charge could become a thing of the past if consumers gravitate to free services.

In fact, AOL has been downgraded twice in recent weeks. Raymond James & Associates cut AOL to "accumulate" from "buy" on Thursday. FAC Equities downgraded AOL Sept. 8 largely on concerns about whether AOL could maintain its pricing.

Those ratings on AOL, however, could change given MSN's move.

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