Beware, Baby Bells

Even though DSL independents like Covad have fallen by the wayside, don't get complacent -- the cable industry is an even bigger threat

By Jane Black

These are grim days for the digital subscriber line (DSL) industry. On Aug. 16, Covad (COVD ), the largest independent provider of high-speed DSL service, filed for bankruptcy protection. Just days before, No. 2 provider Rhythms Net Connections (RTHM ) told its customers it would cease operations.

At least they gave some notice. In March, NorthPoint Communications pulled the plug without warning its customers, many of which were small businesses that relied heavily on DSL.

So who is smiling through all of this? Certainly the Baby Bells, which for months have been profiting from the industry's troubles. The Bells already dominate the DSL market, with 84% share, according to research firm Telechoice. The disappearance of DSL competition seems to have emboldened the Bells: They instituted across-the-board rate hikes -- of 25% in most instances -- over the past few months.


  There may be one other beneficiary from the disappearance of the independent DSL providers -- the cable industry. The Bells ignore cable at their own risk. "The Bells' pricing suggests that they think they have a monopoly and can act as one. This is a great opportunity for cable to grab market share," says Dave Burstein, editor of the industry newsletter DSL Prime.

Signs of cable's push forward already are visible. DSL growth slowed dramatically in the second quarter: Providers added 420,000 subscribers, a rise of 14%, vs. 20% growth in the first quarter and 41% in the fourth. Bankruptcies and rising service rates may have had something to do with the slowing growth.

Yet the cable-modem sector, which is roughly double the size of the DSL market, has reported solid growth of 20% to 25% each quarter. "A few more bankruptcies and a few more price hikes: It's really no surprise the numbers look the way they do," says Adam Guglielmo, a DSL analyst at Telechoice.


  The price hikes should have come as no surprise to customers. Over the past two years -- when there was competition -- the Bells dropped prices to fend off hungry, well-funded upstarts. But as the competition disappeared, the Bells had more maneuver room. In February, SBC hiked monthly rates to $49.95, from $39.95. In May, Verizon upped its prices, with plans now ranging from $49.95 to $79.95 a month. BellSouth and EarthLink also have followed suit.

It's not only a reduction in competition that spurred the price increases. The economics of broadband service never quite added up. During the boom, the cost of building out and providing high-speed service was subsidized by the generous, if sometimes foolish, capital markets. Now those same markets are demanding profits, not growth. And the Bells are trying to deliver.

Whatever the reason, though, analysts say the strategy of increasing prices to improve the bottom line is flawed. "It would be wiser to continue to grab market share by keeping prices in check," says Michael Harris, president of Kinetic Strategies, a broadband market research firm. "It's always cheaper to acquire new customers than to try to lure them from another provider."

Moreover, attracting a critical mass of customers will help bring costs down. The more customers you have, the cheaper it is to run the service.


  Adding customers now is particularly good for the bottom line, since the price of DSL equipment is plummeting. According to Burstein, fierce competition in the equipment market has brought prices down as much as 40% this year. The Bells also have significantly lowered the cost of DSL installation by developing easy-to-use software that allows consumers to get the services up and running themselves. Says Telechoice's Guglielmo: "The Bells are reducing short-term losses in exchange for long-term gain."

Cable, meanwhile, appears to have its eye on the bigger picture. Although operators such as Cox Communications and AT&T also have raised prices, the increases are about half of the DSL price hikes. "The price increases allowed the cable guys to do two things: raise their rates and yet still have an advantage on price. That's an enviable position to be in," says Ian Olgeirson, a broadband analyst at Kagan Communications.

Many customers avoid the increases by signing up for aggressive bundling deals, whereby they receive a discount for buying more than one service. For example, Jean O'Connor, who lives in Ridgewood, N.J., signed up for Cablevision's high-speed service after receiving an offer to pay just $29.95 a month in addition to her regular video service. That was about $5 more than she had been paying Gateway for dial-up access. "The choice was clear because the price was right," she says.

It's not just a good deal for consumers. The more services a customer buys, the more money a cable operator makes, since the cost to run a digital pipe into the home remains steady. Of all the cable operators, Cox Communications has been the most aggressive in bundling video, data, and voice services: Already, 13.7% of Cox customers buy two or more services.


  Besides, slowing growth in the DSL business may not be as menacing a harbinger as it seems. Verizon spokesman Larry Plumb says that despite the slow second quarter, the company is still on track to add 1.2 million new DSL customers by the end of 2001. Plumb and others also insist the rise in prices simply reflects business realities that were ignored during the boom. "There was a tendency to drive DSL to commodity pricing too quickly. It's not there yet," he says.

That may be, but for the moment, cable operators' pricing is clearly more in tune with what the market will bear. And that understanding will translate into millions of customers: By 2005, more than 50% of all broadband customers will get onto the Internet through a cable modem, according to the Yankee Group, a Boston Consulting firm. DSL will capture about 33%, with the remaining customers buying service from satellite or fixed-wireless providers.

The lack of competition should help boost prospects for the Bells in the DSL market, not hurt them. But as the independents fall by the wayside, the Bells better stop behaving as though competition has been cleared away. The cable industry may give them a real run for the money.

Black covers the DSL industry for BW Online from New York

Edited by Beth Belton

Before it's here, it's on the Bloomberg Terminal.