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Tough times for high-speed ISPs despite demand

The basic economic principles of supply and demand apparently don't apply to the broadband market.

5 min read
The basic economic principles of supply and demand apparently don't apply to the broadband market.

Several high-speed Internet service providers and the companies that supply them with high-speed digital subscriber line (DSL) connections are facing serious financial perils, with several companies announcing potential corporate sales, earnings warnings or other untoward news in recent weeks.

Curiously, the downturn comes amid intense excitement over broadband Internet connections. The nascent industry is faced with millions of consumers and businesses that, tired of slower dial-up Net access, are eager for a high-speed alternative.

Why then is the broadband industry struggling when demand for high-speed Net access has never been higher, and the outlook looks so promising?

The answer may be that size matters.

Analysts say that the Baby Bell local phone giants have finally taken command of the DSL market. At the same time, intense competition has forced the smaller broadband providers to spend heavily on advertising and promotion and to cut prices faster than they would like.

"It's really not surprising that these (broadband) guys aren't collecting enough cash to pay their bills," said Dylan Brooks, an Internet-industry analyst at Jupiter Research.

Dozens of smaller broadband--particularly DSL--providers have struggled financially in recent months. Among them, PSINet, an ISP and self-proclaimed "Internet supercarrier," is considering a sale of the company; Covad Communications, primarily a wholesale provider of DSL connections, recently announced layoffs; local phone powerhouse Verizon Communications ended its agreement to acquire NorthPoint Communications after NorthPoint's outlook slumped; New Edge Networks, a broadband provider in smaller cities and rural markets, laid off 135 workers and consolidated its offices in November; Flashcom, a broadband ISP, has been delinquent in paying its bills to Covad; and dozens of others are facing similar financial pressures and tumbling stock prices.

Jato Communications and New Edge Networks, which supply ISPs with DSL connections, and other companies such as PSINet and Flashcom, also have had their share of hiccups.

However, their malaise comes even as broadband growth is on the rise.

According to various estimates, only about 5 percent of Internet users have a broadband connection, offering huge growth potential for the market. Jupiter Media Metrix expects 11.8 million DSL connections by 2005, up from 1.2 million this year.

For one, the major Baby Bell local phone companies are aggressively taking hold of the market. Analysts suggest that the Bells' amplitude allows them to overcome the surprisingly unattractive economics of broadband connections, which have affected smaller competitors.

"The major problem here is that DSL is still so hard to provision," Brooks said. "It's totally out of sorts with a consumer price point that is virtually free to get up and running and which at $40 a month, only offers the ISP about $10 of profit, which is no more than the dial-up guys get at $20 a month.

Placing the blame
Some analysts and industry executives believe the high costs of advertising and promotions, aimed at attracting new customers, is one culprit. Others say that too many competitors forced prices lower more quickly than the small providers ordinarily would have trimmed their rates.

"The number of see story: Telecom downturnplayers in the market led to price competition that is out of sorts with the actual cost of deployment," Brooks said, noting that the Baby Bells, with their scale and wholly owned ISPs, are more capable of absorbing the slimmer-than-expected profit margins.

Many smaller broadband providers have spent money quickly in an aggressive effort to gain market share early.

However, the "If-you-build-it-they-will-come" strategy was resoundingly slapped once the stock markets faltered earlier this year. As a result, the investment capital markets withered, leaving unprofitable start-up broadband companies without a clear means of gaining the money necessary to finish funding their ambitious plans.

"During the first half of the year, the metric being used to measure these companies was growth," said Chuck McMinn, chairman of Covad. "But during the third quarter, the metric quickly changed, and now Wall Street wants profitability."

Others agree that changes in the capital markets had as much to do with the broadband downturn as any operational errors committed by these carriers.

"If the capital markets were as free as they were last spring, some of these companies might have the time to work through their problems," said Drake Johnstone, a vice president at Davenport & Co., a regional equity brokerage firm. "But that seems unlikely now."

Executives at gear-maker giant Cisco Systems, who are watching the carrier market closely to assess its potential impact on sales, say they continue to focus on customers that use their financial assets intelligently to build their networks. They note that those companies are learning from the mistakes of some of their peers.

U.S. broadband acceleration
Cable modem and DSL use is expected to grow steadily over the next five years, leading the way for high-speed Net access.
(Homes in millions) 1999 2000 2001 2002 2003 2004 2005
Cable modems 1.4 3.3 5.5 7.9 10.1 12.1 13.8
xDSL 0.3 1.2 2.5 4.4 6.8 9.3 11.8
Satellite 0.1 0.1 0.3 0.5 0.8 1.1 1.4
Fixed wireless 0 0.1 0.2 0.4 0.8 1.3 1.8
Dial-up 43.6 48.4 51.2 52.6 52.9 52.1 51.4
Total 45.4 53.1 59.7 65.8 71.4 75.9 80.2
Source: Jupiter Media Metrix
"Those that were being capital inefficient are being winnowed out first," Kevin Kennedy, senior vice president of Cisco's service provider line of business, said at the company's financial analyst conference this week.

The capital shortage is not alone in its blame for the DSL industry's struggles. Some industry experts say these smaller competitors set expectations too high at a time when the Baby Bells weren't really in the game. Now that these local phone giants have kicked their sales machines into high gear--forsaking concerns that DSL sales could cut into older technology alternatives like ISDN and T-1 lines--Bell companies such as SBC Communications, Verizon and BellSouth are dominating the market.

Although most Baby Bells are concentrating on the residential consumer market, they also are adding business customers that generate higher profit margins, which cuts into the niche occupied by many of the smaller providers. In turn, a greater percentage of the smaller players' new customers are low-cost consumers.

Still, in spite see story: Find a broadband providerof the woes among dozens of smaller DSL providers, analysts and executives argue that the broadband market remains strong, and demand is peaking--with or without smaller competitors.

"I don't care if there are 1,000 small broadband ISPs who are hurting. Compared to the (Baby Bells) it's a pin prick," Johnstone said. "The (local phone companies) are signing up the lion's share of DSL lines.

"The broadband market is growing by leaps and bounds despite the bad news about Covad, NorthPoint and the others," he said.

News.com's Ben Heskett contributed to this report.