Commentary: Broadband's Pioneers May Get Beaten, Then Eaten

If the Baby Bells are the turtles and the upstart phone companies the hares, it's now clear that the turtles are winning the race to wire the world for high-speed Internet access. On Nov. 20, San Francisco-based NorthPoint Communications Inc. restated third-quarter earnings because of delinquent customers. Five days earlier and for the same reasons, Covad Communications Group Inc. of Santa Clara, Calif., lowered its results, which were already poor enough to force Covad President and CEO Robert Knowling to resign on Nov. 1.

Both Covad and NorthPoint build DSL networks, short for digital subscriber lines. It's a technology that allows phone customers to get far faster Internet access than what's normally available through traditional phone lines. A promising idea, DSL companies were until recently a sizzling-hot market for investors. Now they're in the dumpster. The combined market value of Covad, NorthPoint and a third stand-alone DSL company, Rhythms NetConnections, Inc., has fallen to $1 billion from $10 billion in January. "In 1998, people were throwing money at us. Now, the day of reckoning has come," says Knowling.

Boy, has it ever. Increasingly, the upstart DSL companies are being hit by stiff new DSL competition from the former Bells and from companies that offer high-speed access over TV cable lines, like AT&T's AtHome service. That's keeping the price of basic DSL service at around $40 per month. Moreover, while those larger players have deep pockets for their ambitious rollouts, the DSL companies have had trouble collecting from mom-and-pop Internet service providers who resell their DSL services. Both NorthPoint and Covad blamed these small providers for their deteriorating financial condition. "There's not enough value in that supply chain to sustain all these companies," says Reed Hundt, former chairman of the Federal Communications Commission and now a NorthPoint board member.

The result: The DSL upstarts are now drowning in red ink. Through the first nine months of 2000, Covad, NorthPoint, and Rhythms NetConnections of Englewood, Colo., have lost a combined $1.15 billion on sales of $279 million. With their current spending plans, none is expected to be profitable before 2003. Yet the three have had to spend hundreds of millions of marketing dollars to win customers. Unexpected technical and installation snafus have also taken their toll. "It was harder than we thought it would be," says Elizabeth A. Fetter, NorthPoint's president and CEO.

Meanwhile, the Bells, while slow out of the gate, are catching up fast. They've been able to leverage their existing customer base, ramping up marketing campaigns and signing up new customers more quickly and cheaply than the stand-alone DSLs. In the third quarter alone, for instance, SBC Communications signed up 117,000 subscribers, while Covad, Rhythms, and NorthPoint added a combined 108,000.

EMERGING LEADER. The irony for the threesome is that their troubles have hit at just the point in time when demand for DSL service is booming. The number of DSL lines is expected to reach 11.3 million in 2003, up from 2.3 million in 2000. Analysts expect DSL will pass cable as the most popular broadband connection in 2003.

Now, with their cash running out, the independent DSL providers need partners to survive. In August, NorthPoint said it would merge with the DSL unit of Verizon Communications, which paid $800 million in cash for a 55% stake. And SBC paid $150 million for a 6% stake in Covad in November. "We're a scarce asset. There are a lot of folks interested in us," Rhythms President and CEO Katherine Hapka says.

For good reason. All three upstarts have built up a nationwide DSL reach that the Bells lack. Should any of the four regional Bells invade one another's turf, buying one of the upstarts would be easier than building from scratch. And thanks to their diminished market caps, "these companies are low-hanging fruit," says Jeffrey Kagan, an independent telecom analyst in Atlanta. If that happens, consumers and small businesses will get broadband from the same place grandma got her voice line: the local phone company.

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