Business and Finance - ISP Becomes a Four-Letter Word

Internet Providers' Failure to Pay Imperils DLECs

In the early days, there was nothing but kind words for these ISP partners, who held the potential of being a lucrative channel for the DLECs' bread-and-butter product.

Fast-forward a few years. Now when you mention some of these ISPs, all you may hear from DLECs is a string of expletives.

Financial problems befalling the ISPs are filtering down and having an adverse effect on the DLECs. Some ISPs can't pay their bills for DSL lines, thus causing DLECs to miss their quarterly revenue goals, and in some cases even causing them to restate previously announced numbers.

"ISPs in general are having a hard time," says Jeff Moore, a senior analyst for network services at Current Analysis Inc. (www.currentanalysis.com). "And it's a virus that's catching. It's translating into problems with the data LECs."

Hit particularly hard by the ISPs' misfortunes have been Covad and NorthPoint.

Less than a month after posting its third-quarter 2000 earnings, NorthPoint revealed that its ISP partners' inability to pay their bills would actually reduce third-quarter revenue by $6 million, for a total of $24 million in revenue for the period. As a result, EBITDA losses grew too, to $90.9 million vs. the loss of $79.2 million the company reported initially.

These changes and the resulting chill on NorthPoint's stock led to much more dire consequences for the company. Verizon Communications (www.verizon.com), with whom NorthPoint was planning to merge to create a national broadband play out of combined DSL operations, decided to cancel the impending nuptials.

Covad too had a similar restatement of third-quarter results with which to contend. The company realized after posting its initial numbers that 14 of its ISP partners, representing about 65,000 of its 200,000 DSL lines in service, were in arrears with their payments. Four of the ISPs--Flashcom Communications (www.flashcom.com), Zyan Communications Inc. (www.zyan.com), Relay Point Inc. (www.relaypoint.net) and FastPoint Communications Inc. (www.fastpoint.com)--were in such dire straits that they were seeking bankruptcy protection. Covad's third-quarter revenue dropped by $10.4 million to $56.3 million after the restatement, with EBITDA losses growing by $4.9 million to a total loss of $125.3 million.

Following Covad's and NorthPoint's announcements, other DSL providers tried to make it painstakingly clear that they weren't as open to the risk of the ISP virus.

Rhythms, for example, said that it was moving Flashcom's customers over to the Rhythms network. And Rhythms' other major ISP partner, Telocity Inc. (www.telocity.net), indicated that it was funded into 2001, and was not at risk of defaulting on payments.

Mpower Communications Corp. (www.mpowercom.com) said in an early December statement that it was facing no problems because it strictly provides DSL lines direct to its customers, rather than acting as a wholesaler.

And, the privately held New Edge Networks Inc. (www.newedgenetworks.com)says that it's not experiencing the same problems in its second- and third-tier markets because there is scant competition from other DSL providers. The company also believes that it has teamed up with small, but financially strong, local and regional ISPs in those markets, according to company spokesman Sal Cinquegrani. Plus, he notes that more than 80 percent of New Edge Networks' revenue is coming from non-DSL services, such as WAN, VPN and frame relay.

This kind of diversification is the key to future success in the DSL business, say industry analysts.

"To some extent, they've positioned themselves as being a provider of high-speed Internet access. That's great, but it's only part of the solution," says Moore. "They need to position themselves as a provider of broadband networking services via DSL, and focus on climbing the value-added ladder."

DLECs and their ISP partners need to make sure provisioning, customer service and billing are streamlined. DLECs also need to make sure that lines of communication with the ISPs are open enough that customers can get timely access to information and installation of their DSL lines, says Steven Weinberg, director of research for New Paradigm Resources Group Inc. (www.nprg.com).

Until those issues can be worked out, the DLECs in hot water are trying to put out the fires created by their less-than- stellar ISP partners.

For instance, NorthPoint filed a lawsuit against Verizon on Dec. 8 to obtain damages and injunctive relief following Verizon's termination of its agreement to merge the two companies' DSL businesses. The suit, which was filed in the California Superior Court for the City and County of San Francisco, seeks damages of up to $1 billion or more in a jury trial. NorthPoint says that Verizon's termination of the pending merger was without legal or factual basis, and that Verizon is attempting to avoid its investment obligations under the merger agreement and thereby increase its near-term stock price.

Covad, after being plagued by nonpaying ISPs and the market downturn, revealed some strategic changes that will hopefully give it long-term staying power. Covad said it plans to strengthen its distribution channels, relying more on sales of DSL lines by financially sound ISP partners and its own internal sales organizations. The company also plans to halt its network growth at 2,000 COs and concentrate on adding more customers to its existing network.

"Our industry has faced difficulty recently," Chuck McMinn, Covad's chairman, said during a press conference announcing the new strategy. "By making these changes, we've adjusted course as a result of market conditions to get to profitability."

The most important move Covad is making is the refocusing of its ISP sales channel. "It's disappointing to have such a large amount of our ISP customer base deteriorate so rapidly," said McMinn, noting that overall, about 26 percent of Covad's total installed lines are from troubled ISPs, and another 32 percent of lines are from potentially weak ISPs. These potentially weak ISPs are currently up to date on payments to Covad, but are on shakier financial ground than the company's Tier 1 ISP partners.

Covad also debuted its SafetyNet program, which is focused on transitioning DSL end users from troubled ISPs to other, stronger ISP partners, or Covad's own retail ISP service. "We've had quite a few requests from customers asking about switching ISPs when they're dissatisfied with their current ISP's support," says Chuck Haas, Covad's co-founder and vice president, who is spearheading the SafetyNet project. "We figured the best way to do this is to put together a formal program."

Covad also plans to focus more of its new line growth among its "Gold Tier" ISP partners, which include AT&T Corp. (www.att.com), EarthLink Inc. (www.earthlink.net), UUNET (www.uu.net) and XO Communi- cations Inc. (www.xo.com). During the third quarter 2000, Covad reported that less than 50 percent of its lines were coming from these Gold Tier partners.

McMinn said that he also expects to derive more new lines from two of the company's internal divisions, Covad Integrated Services and Covad Business Solutions.

Covad revised its financial and operational expectations for 2001 as a result of these changes. The company expects to have 440,000 to 460,000 lines installed by the end of next year vs. previous analyst expectations of 600,000. Expected revenue will be $380 million to $390 million, with EBITDA losses decreasing up to $100 million for total EBITDA losses of $450 million to $470 million.

McMinn said that capital expenses will also be reduced by $100 million to approximately $250 million. The monthly cash burn rate will also decline, from $75 million expected in the fourth quarter 2000 to $60 million by the end of 2001. With that decline, McMinn believes the company will be fully funded into 2002.

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