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The Starting Line: SBC looks for DSL boost from Prodigy

SBC Communications' desire to acquire the rest of Prodigy Communications can be explained in three simple letters: DSL.

SBC Communications' desire to acquire the rest of Prodigy Communications can be explained in three simple letters: DSL.

Last Friday, SBC said it plans to purchase the outstanding Prodigy shares it doesn't already own for $5.45 a share, for a total of around $378 million, including debt. Investors cheered the deal Monday, pushing Prodigy shares up more than 56 percent.

Why buy Prodigy now? Market analysts said the timing, and price, are right. SBC needs an Internet service provider in its family to offer next-generation DSL (digital subscriber line) services. Furthermore, with SBC executives sitting in most of the top spots in the company and a recent cash infusion to help prop up the ISP, SBC didn't have to do much to seal the deal.

"We've been contemplating this for a while," said SBC spokesman Selim Bingol, who added that the fate of Prodigy's brand name hasn't been decided.

Seeking broadband success
SBC has been less than successful with its own DSL expansion plans. In this light, SBC's effort to bring Prodigy into the fold makes sense, analysts said. To deliver on its grandiose plans, SBC needs to own its own ISP.

"SBC is effectively seeking to gain end-to-end control of the DSL provisioning and maintenance process, rather than share it with an uncontrolled partner," said ABN AMRO analyst Gregory Miller. "We have already witnessed multiple failures among the DSL resellers."

DSL is seen as a natural growth path for many regional Bell operating companies, but the execution of this strategy has been spotty at best. Technology issues, prolonged wait times for installation, and higher prices have frustrated many consumers.

Yet as many independent DSL providers have folded, such as NorthPoint Communications and Rhythms NetConnections, the Baby Bells have found themselves at an advantage in the broadband market.

Ties that bind
SBC Communications effectively controlled Prodigy before offering to completely buy it. Here are some of the connections that tie the companies together:

1. On Nov. 19, 1999, SBC and Prodigy announced a strategic relationship, expanding the deal in May 2000. SBC's initial investment was valued at $560.8 million. SBC contributed hardware and subscribers; Prodigy contributed assets, including employees. SBC also exclusively marketed Prodigy's Internet service.

2. Prodigy CEO Paul Roth and CFO Allen Craft, along with other key executives, were former SBC employees.

3. About 37 percent of Prodigy is owned by Telmex, also partially owned by SBC. Carlos Slim Helu, who controls Telmex, also owns a large portion of Prodigy and sits on SBC's board of directors.

4. SBC extended a $110 million revolving credit agreement on Jan. 1. As of June 30, Prodigy has borrowed $15 million.

Sources: Prodigy, SEC filings, Banc of America Securities

SBC has touted its "Project Pronto" and recently detailed plans to offer online gaming and video-on-demand services. Although SBC has landed the most DSL subscribers of any Baby Bell, some analysts have noted that the company's subscriber growth hasn't been too impressive overall.

Enter Prodigy. With the purchase of the fourth-largest ISP behind AOL Time Warner, MSN and EarthLink, SBC is essentially buying "Internet expertise," said Rob Lancaster, an analyst at The Yankee Group.

According to Lancaster, SBC can take Prodigy's dial-up subscriber base and have those customers trade up to DSL and other broadband services. SBC can also take advantage of Prodigy's well-known brand name.

"Prodigy gives SBC a national reach," Lancaster said.

Other analysts note that SBC could also use Prodigy's marketing help. "We think the transaction highlights the fact that SBC has had a difficult time in marketing its DSL service," said Andrew Hamerling, an analyst at Bank of America.

"Through this acquisition, the company is effectively buying a high-quality marketing arm for its dial-up ISP and DSL subscriber services," Hamerling said.

Will Prodigy juice SBC's DSL growth? Analysts are split, noting it will take a few quarters to tell. Telecom companies' ISP efforts haven't been vibrant largely because they haven't been a priority, analysts said.

Indeed, Verizon Online, AT&T Worldnet and all trail Prodigy in subscribers, according to The Yankee Group.

If SBC allows Prodigy to maintain its current business model, SBC may be able to reap some subscriber rewards. Yet if SBC makes to change the Prodigy strategy too much, the service could join the ranks of other lackluster online efforts.

"Phone companies don't make good online services," said Peter Decaprio, an analyst at Thomas Weisel Partners. "SBC should leave Prodigy independent."

The EarthLink factor
Perhaps the biggest winner in the SBC-Prodigy deal is EarthLink, an ISP that Wall Street has pegged to become a takeover target.

EarthLink, one of the last remaining independent ISPs, would be an attractive takeover candidate for a lot of companies, including Microsoft's MSN and media companies such as Disney, said Thomas Morabito, an analyst at McDonald Investments.

Morabito said EarthLink has more subscribers, a strong customer service unit, and more cash than Prodigy. Meanwhile, EarthLink isn't tied to any one large carrier that would prevent a takeover.

"This deal just makes EarthLink look better," Morabito said.