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United Online: Value ISP, Pricey Stock

By Amy Tsao Mark Goldston, chief executive of United Online (UNTD), likes to compare his dial-up Internet service provider (ISP) business to no-frills airline Southwest (LUV). He says both have low-cost infrastructures, and both are taking customers away from giants. "People thought we were crazy," says Goldston. "We were viewed as a flawed strategy. But they said the same thing about Southwest."

Goldston may be right to make that analogy. The biggest ISPs have premium features to tout, but a certain segment of the population just wants a good deal. United, in Westlake Village, Calif., provides only so-called narrowband service and positions itself as a "value" player through its discount brands NetZero, which initially made its name offering free service, Juno Online, and Kmart's Blue Light Internet service. United now has some 2.4 million subscribers who pay $9.95 a month -- a steep discount to the big-name operators that charge on average $25 a month.

None of United's brands comes close to having the market share of leaders America Online (AOL), which, with 26 million subscribers, is the No. 1 ISP, Microsoft's (MSFT) MSN, or Earthlink (ELNK). And the long-term trend points to rising use of high-speed broadband service. Analysts caution that the ISP market will get tougher for everyone since more than 50% of U.S. households already have Internet access.

FIRST PROFITABLE YEAR. For now though, United continues to deliver results -- at the expense of the larger ISPs that still offer dial-up service. In fiscal 2003 ending June 30, it's expected to have its first-ever profitable year. It boasted net income for the fiscal third quarter ended Mar. 31 of $7 million (25 cents per share), beating consensus expectations by 19%.

Fundamentals for United are attractive, but investors may want to wait for the stock price to pull back before jumping in. The shares have been flying high, up 177% in the past 12 months. At $22, United's price-to-earnings ratio is about 21 times consensus fiscal 2004 earnings of $1.06 per share.

Little wonder that on Apr. 29, First Albany analyst Youssef Squali downgraded the stock to buy from strong buy. And Mark Zadell, an analyst at Blaylock Partners, had already cut his recommendation to sell on Apr. 23. Both analysts cited valuation for their downgrades.

EXPIRING CONTRACTS. If the stock takes a dip, it could present a buying opportunity because analysts expect that over the next few years, United should keep attracting users from its pricier competitors. It added 229,000 subscribers in its March quarter, and it should add similar numbers as thousands if not millions of customers on multiyear contracts seek a cheaper alternative when their expiration dates approach, figures Squali.

He points out that a large percentage of MSN customers who paid roughly $10.85 per month after a $400 sign-up rebate "are likely to either upgrade to broadband or downgrade to a $9.95 service, but not to another premium ISP, such as AOL or EarthLink." (Squali's firm hasn't done banking for United.)

Down the road, the changing demographics of Web users may also help United. At the start of the Internet boom, ISP customers tended to have higher-than-average household incomes. But market researcher IDC expects that some 61% of households with annual income of under $35,000 will be online by 2007, up from 21% as of the end of 2002. "These people will buy PCs for $300 or $400 at Wal-Mart (WMT) and Target (TGT), and they'll pay $9.95 for Internet access," Goldston predicts.

NO CONTENT. These numbers are compelling, and United is poised to benefit as folks who earn less look for affordable online service. Also, United boasts that its customers like not having to sign long-term contracts, the technique used by the larger ISPs to lock in customers.

Already, the discount market is seeing competition, though for the time being it's "at the margin," says Richard Klugman, an analyst at Jefferies. Through a deal with PeoplePC, Earthlink offers a $16 product. SBC Communications (SBC) and Yahoo! (YHOO) sell a $16 service. And AOL through CompuServe and a joint venture with Wal-Mart sells a $10-per-month ISP. (Krugman doesn't own stock in United, and his firm hasn't done banking with it.)

What United Online doesn't have is content, and the debate continues to rage over how important that is to Net surfers. And broadband use, though still pricey, will continue to increase over the long haul. IDC estimates that 29% of Internet users had broadband in 2002, and that will rise to 60% in 2007. In fact, the big players seem to be more focused on how to transfer customers over to their high-speed offerings than on stemming losses to outfits like United.

SPEEDY DIAL-UP? However, as long as companies that sell broadband service have to lease infrastructure from phone and cable companies, their margins will be thin. In turn, pricing on the dial-up side won't likely drop near United's, says Standard & Poor's Internet analyst Scott Kessler.

In any case, United Online's Goldston say he has a dial-up answer to broadband. For $14.95 a month through Juno SpeedBand and NetZero HiSpeed, more budget-conscious types can get dial-up service that's faster than conventional dial-up, though not quite as fast as broadband and that still ties up a phone line. Goldston says beginning this quarter, United will spend 40% of its media budget on selling these faster services.

Ultimately, United Online, while it may do well over the next several years, will have to upgrade to other offerings. Analysts expect broadband to become the standard and dial-up to die a slow death. "From an organic perspective, there isn't huge upside for United," says Kessler.

However, the transition likely will take many more years. In the meantime, United is poised to win a good chunk of business from customers who want to go online on the cheap. That should be good news for investors willing to wait for the stock price to drop. Tsao covers financial markets for BusinessWeek Online in New York

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