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ISPs hold on to their market

The telcos were supposed to squash independent ISPs, but they're still growing. What gives?

While many industry watchers had expected independent ISPs to get trampled this year by a herd of telecommunications companies, many are in fact posting revenue growth while others are still entering what was supposed to be a shrinking market.

BBN (BBN), PSINet (PSIX), and Netcom (NETC), for example, posted revenue growth ranging from 32.7 percent to 85 percent in the December quarter, compared to year-ago figures.

The number of ISPs nationwide has also grown to about 4,100 from less than 1,000 a year ago, said Eric Paulak, an analyst with Gartner Group.

That is a big surprise to Paulak and other analysts. Last July, Paulak said he expected the number of ISPs to top out by the end of summer 1996 as giant telcos like AT&T, MCI, and Sprint entered the market. But the number of ISPs has grown by more than 1,000 since then.

Analysts say they simply underestimated the growth in demand for Net access. Paulak also notes that many of the new players are simply adding Net access services to their existing business, rather than launching an ISP from scratch. This means that customers still have more ISPs to choose from, but not all of these new players are betting the house on their ISP revenue.

"Second-tier long distance and reseller companies have jumped into this market to provide a value-added service," Paulak said. "IDT, for example, made a splash last year when it got into the Internet service."

The small to medium-sized ISPs have also taken advantage of the fact that the large telcos were more incompetent than anticipated, analysts say.

"I think the [telcos] haven't done a good job. They were late to the game, haven't been aggressive in marketing, and their numbers haven't been as large as we thought," said Youssef Squali, an analyst with Laidlaw Equities.

That may be because the telcos are distracted with the ongoing deregulation of their industry. "Protecting their own turf has been a No. 1 concern for them. And this has taken a lot of their time, including spending a lot of time in court to do this," Paulak said.

Analysts still think many players will drop out and expect consolidation of the industry to heat up in the near future. Paulak predicts that by the year 2001, 80 to 90 percent of the market will be gone, leaving only about 400 to 500 ISPs.

And analysts caution that while the rising growth of the Internet has brought ISPs new revenue, the percentage of growth has slowed compared to the first Net boom years, especially for ISPs who serve the consumer market.

In the consumer space, as expected, revenue growth has been tempered by the increased competition represented by the telcos and the industrywide move to flat monthly fees. ISPs serving the corporate market face less competition on pricing and will see less erosion of their revenue growth rates, analysts added.

Netcom, which caterered to the consumer market until it switched its allegiance to the business market late last year, reported revenue growth of 324 percent in 1995 over the previous year. But the company is expected to grow by only 45 to 50 percent this year, Squali said.

PSINet, which has always marketed itself to the business community, posted revenue growth of 155 percent in 1995, over the previous year. The company is nevertheless expected to see a slowing growth rate of 60 to 70 percent this year over year-ago figures, Squali said.

Over time, this slowing growth rate could still cause problems for ISPs like PSINet.

Rakesh Sood, an analyst with Hambrecht & Quist, said he has since lowered his 1997 revenue projections for ISPs from his estimates six months ago. Shares of PSINet, Netcom, and BBN have all lost about half their value since last January.

Netcom is not expected to post profits until 1999 at the earliest as it completes its transition from the consumer to the corporate market, Sood said. PSINet, which is further along in the corporate market and already has its network in place, is expected to post profits in the fourth quarter of 1998.

Still, the telcos have proven less formidable opponents than they at first seemed. It now looks like large telcos may end up purchasing the smaller Internet companies to bolster their array of services, just as MFS Communications acquired UUNet Technologies in a $2 billion deal last year.