Covad tries an end run

Kicked around for years by regulators and local phone giants, broadband pioneer Covad is taking its future into its own hands.

Covad--one of the few start-ups to survive the telecom shakeout--on Tuesday said it had begun selling Internet phone service to customers in 42 cities. At first glance the announcement read like another product release, but Covad's entry into the VoIP (voice over Internet Protocol) market underscores the company's efforts to preserve its future as its present business is threatened by an uncertain regulatory landscape.

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What's new:
As broadband upstart Covad watches its federally enforced deal with the Baby Bells unravel, it may have to find other ways to deliver services--or other services to deliver.

Bottom line:
Internet telephony may be the ace Covad needs now that the Bells seem to hold all the cards and its "destiny" is in danger.

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Born from the Telecommunications Act of 1996, Covad has made a strong run at selling broadband DSL access to consumers and small companies. But much of this consumer business is in jeopardy because parts of the Telecom Act are being dismantled.

"The problem for Covad is they've been a regulatory football," said Scott Cleland, chief executive at market research firm Precursor Group.

Covad's rise, fall and resurgence mirror the convoluted course of the nation's telecommunications laws. The Telecom Act, which forced the Baby Bell phone companies to lease their copper lines to start-ups at regulated rates, allowed Covad to tap into the growing demand for fast Internet access.

The Federal Communications Commission hoped the Telecom Act would allow a hundred start-ups to blossom on the backs of the Baby Bells' copper wire networks. But the Bells, which built these networks, were not happy about it and complained to regulators that supporting these start-ups hurt their businesses.

Eight years later, the pendulum is swinging favorably for the Bells, a group that includes SBC Communications, Verizon Communications and BellSouth. Many of the rules spelled out by the Telecom Act are in preliminary stages of elimination. Most pressing for Covad is the threat to pull back "line sharing" and to remove regulated lease rates for third parties. If line sharing disappears, Covad would have to hike prices for new DSL customers.

"Covad, like any company focused on copper, has no long-term future in North America," said Albert Lin, an analyst at American Technology Research. "If you're not a (Baby Bell), I can't see how you could construct any business model that works."

"Given the shifting regulatory environment, the long-term (plan) is to get more control over our own destiny." --Charles Hoffman, CEO, Covad

The Bells are having their final say. Beginning in October, the local-phone giants will no longer need to share their lines with broadband resellers such as Covad, according to a regulatory filing by the company in July. Instead, third parties must strike their own deals with the Bells, which could drive up consumers' price for DSL, or face having to purchase separate phone lines to resell, which definitely would raise costs.

"We value our wholesale customers," SBC spokesman John Britton said. "We want to keep our wholesale customers on the network at prices where SBC is not subsidizing them."

The idea of killing "line sharing," as the provision is called, has loomed over Covad since February 2003, when the FCC rewrote its telecom rules. Covad can strike deals with the Bells to continue line sharing, as it did with Qwest Communications in April. But Covad won't have the benefit of regulations that force the Bells to agree to prices more favorable to the start-ups.

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"It really showed our commitment to working with our wholesale customers and our commitment to fair, market-based competition," Qwest spokeswoman Claire Mylott said. She declined to comment on the terms of the new line-sharing deal.

Covad is already preparing itself for the rule change. In the filing with the Securities and Exchange Commission the company warned that after the October deadline it would have to strike more deals with the Bells to allow line sharing, as it had with Qwest. If Covad cannot reach an agreement, the Bells could force it to buy separate phone lines, rather than the data portion of a line, to serve customers in a given region.

"If this occurs, the company may stop selling standalone consumer grade services to new customers, because the cost of a separate telephone line is significantly higher than what the company currently pays for the shared line," the filing read.

Covad's best hope rests with FCC Chairman Michael Powell, who is working to broker a deal with fellow commissioners to preserve line sharing. If Powell succeeds, the decision could become the lifeline Covad needs to keep its DSL business afloat, at least for the time being.

Keeping its head above water
Covad is no longer willing to bet its future on the outcome of regulatory deal-making that is out of its control. The past 18 months have forced Covad to take a more aggressive look at crafting a future apart from the Bells--and this future begins with VoIP.

"Given the shifting regulatory environment, the long-term (plan) is to get more control over our own destiny," said Charles Hoffman, the company's chief executive.

To its credit, Covad has survived in a market riddled with failures. The demise of former competitors such as Rhythms NetConnections and NorthPoint Communications represents a contrast to Covad's disciplined management of its operations and finances.

"Covad's advantage was that the Bells were in DSL hell." --Dave Burstein, publisher of DSL Prime

Much of Covad's rise in the late 1990s was fueled by selling businesses access to dedicated DSL lines that weren't shared. Also, Covad got a head start selling DSL to households while the Bells dragged their heels in major markets.

The Bells these days have gotten their act together and are aggressively cutting prices and packaging DSL with other services such as wireless phone and satellite television.

"Covad's advantage was that the Bells were in DSL hell," said Dave Burstein, publisher of industry newsletter DSL Prime. "When the Bells' services became OK, why go to Covad?"

Executives and analysts observe that Covad has invested heavily in its network and has reached enough mass to lower operation costs and increase margins per customer. In the quarter ended June 30, its DSL lines jumped 13 percent from a year earlier to 514,000. Consumer subscriptions accounted for 292,200 lines, while its business customers reached 222,200.

Streamlining its DSL business helped the company lower its net losses to $7.4 million last quarter on $107.3 million in revenue. That's a healthy improvement from last year's $27.3 million in net losses and revenue of $92.4 million.

Wholesaling DSL lines to largest partners EarthLink and AT&T now contributes 17 percent and 14 percent, respectively, to its total revenue.

The VoIP savior?
Covad executives know that despite improved finances and some support from the FCC's Powell, the company cannot rely on the Telecom Act to keep its business growing.

Change began in March when Covad acquired a Silicon Valley start-up called GoBeam for $48 million in stock. The deal pushed the company into the crowded VoIP ring, which telecom giants, including the Bells, are planning to enter. Even the venerable AT&T is pinning its future on VoIP, now that it will no longer pursue new residential phone customers.

The GoBeam acquisition could act as a doorway for Covad to strip its fortunes away from the Bells' control. Unlike traditional phone lines, VoIP is not federally regulated, nor is it dominated by a handful of companies. Since VoIP technology uses the Internet to transmit digitized packets of audio, anybody can offer it without relying on incumbent phone networks.

By all expectations, VoIP will explode over the next several years. In the United States alone, Net phone services will reach 5 million subscribers by 2007, according to Stratecast Partners. The market will find a significant presence in businesses, where 1.7 million VoIP lines will be found through IP PBXs (private branch exchanges), according to Forrester Research.

"VoIP is a big opportunity," Covad's Hoffman said. "We own our own network, so we're not reselling someone else's network."

But VoIP will come at a cost. In its earnings report, the company warned that the cost of marketing its VoIP business will end its steady improvements in net income. Next quarter, Covad expects expenses of rolling out VoIP to contribute to a net loss between $21 million and $25 million.

Aside from the hype surrounding VoIP, the company is planning to jump onto other promising bandwagons such as wireless broadband access. Many companies are keeping a close eye on a wireless standard called WiMax, which only recently achieved industrywide agreement on technical specifications for developing products. WiMax proponents say the technology will deliver a broader transmission range to more homes and devices.

Covad executives were mum about their investment in WiMax technologies. Options include building out their own wireless networks in certain markets or partnering with network providers. Either way, Covad executives view wireless broadband as a clean slate to sell access without the Bells breathing down their necks.

Executives hope "there are folks we'll be happy doing business with and not having the problems that we've had with the (Bells)," said Ron Marquardt, Covad's technical director.

News.com's Ben Charny contributed to this report