To all AOL Longs.. re: Free isps. An interesting article..
Industry Analysis
Dec 22, 1999
Internet: Junos Internet Service: The Best Things on
The Web Arent Free
Staff Writer: Eliot Walsh (12/22/99)
Free Internet service providers have captured the hearts of investors and
consumers alike, but their underlying business models are not as exciting
as they seem.
Two free ISPs ruled tech stocks Tuesday. Shares of Juno Online Services
(NASDAQ:JWEB - news) soared $37.75 to a 52-week high of $66.75. As
recently as Friday, the shares were only worth $16.38.
But the stock must have eaten rocket fuel for breakfast on Monday, when shares jumped to $29. Today, the stock is up
another $3.81 to $70.56, although it had been up as much as $8 early in the session.
Oh well! Just another wacky, wonderful day in the world of Internet stocks.
But there?s a reason for this surge. The company just announced it will offer free Internet access to bolster
subscriptions to its fee-based service, and now investors can?t buy its shares quickly enough.
Juno also has coattails. Netzero (NASDAQ:NZRO - news) , another ?free? ISP, gained $10.38 to $33.94 after also
trading to a 52-week high of $34.36. But in the first hour of Wednesday?s trading, the stock is down $6.44 to $27.50.
Both companies and most of their lesser-known competitors basically work the same way. Users who sign up for the
free services first download the ISP software, then fill out a questionnaire regarding their consumer preferences.
When they surf the Net, an ever-present window scrolls targeted advertisements whose content is based on the
preferences users specified. In addition, the ISP tracks each user?s Net-surfing habits, also to the end of delivering
highly targeted ads.
Sounds like an advertiser?s dream come true, right?
Not necessarily.
According to the business model, ad and e-commerce revenues will offset operating costs and the cost of goods
sold?in this case, the communications costs ISPs must pay to network operators to use their infrastructure as well as
the cost of customer acquisition, or COA.
In theory, the free ISPs should benefit from both their rapid subscriber growth and the detailed database of their
customer preferences. The customer data should enable the ISP to charge higher ad rates than fee-based services such
as America Online (NYSE:AOL - news) .
But there?s a catch. As the industry exists now, the free ISPs? ad revenue isn?t going to grow fast enough to cover their
costs.
Costs exceeding sales is pretty much the norm among Internet stocks, but most indications are that free ISPs have
higher obstacles than other Internet companies on the road to profitability.
When the British pioneer of the free ISP business model, FreeServe, steamrolled the more costly America Online UK
with its absence of fees, many believed they were witnessing an ominous precedent for AOL?s fortunes in its home
U.S. market.
But in the U.K., unlike in the U.S., customers pay a per-minute charge to the phone company, which significantly
raises the price of Net access. FreeServe, meanwhile, enjoyed a part of the telecoms? profits from FreeServe users--a
steady stream of revenue American ISPs do not have.
This past August, Microsoft (NASDAQ:MSFT - news) said it, too, might offer free Internet access. At that point, we
wrote that they couldn?t afford it without intentionally operating at a loss.
According to Warburg Dillon Read analyst Michael Wallace, America Online pays carriers like MCI WorldCom
(NASDAQ:WCOM - news) and Sprint (NYSE:FON - news) an average of $10.25 per user per month for the use of
their pipes.
Other expenses, including customer service, cost of merchandise, content royalties, billing expenses and data center
costs, run the company an additional $5 to $6 per month.
Although analysts believe communications costs are steadily subsiding, NetZero and Juno would still have to cover a
huge cost with advertising revenues alone. Netzero is able to cover its customer service costs by charging $14.95 per
occurrence to speak to customer service rep. But even if the companies could cut communications costs in half,
providing service would still be expensive.
In fact, Paine Webber analyst Jim Preissler estimates Juno pays roughly $5 to telecommunications partners for
connection, although he thinks that rate could drop.
To make that up in ad revenue, free ISPs have two choices: They can stretch their already skin-and-bones service to the
absolute limit, and hope people don?t mind busy signals and expensive customer service. Or they have to outperform
America Online, which itself earns more than $5 per user per month--and no corporation in the world generates more
ad revenue than AOL.
Add to that a high-level of churn (over 100% a year for FreeServe) and higher competition, and the cost of customer
acquisition starts going through the roof. As analyst Youssef H. Squali of ING Barings in a recent industry report, ?As
more and more free ISPs try to build scale and attract advertisers, the COA could remain at relatively high levels and
providers could have a difficult time raising their CPMs.?
CPM is the rate that advertisers pay Internet companies per thousand hits.
Squali is also skeptical about the strength of advertiser demand for the free ISPs customer profiles.
?Given the fact that the service is popular with first time Internet users, teens, and college students, the attraction of
such a service to advertisers may need further proving,? he notes.
Squali estimates that for NetZero to turn cash flow-positive by the fiscal first quarter of 2003 and to generate an actual
profit in the fiscal third quarter of that year, communication costs have to drop 56%, CPM has to rise 133%, and the
COA has to stabilize at $50 to $60 per customer. A growing number of current users are migrating to high gates of
high-speed services such as digital subscriber line, or DSL, and cable modems. Moreover, consumers are frustrated
that these services aren?t becoming available fast enough.
The Internet may have turned a lot of conventional wisdom on its head, but on the Net, as everywhere else, as the
saying goes, ?There?s no such thing as a free lunch.?
For now, free ISPs will probably be highly popular with a relatively small segment of Net users. Providers will stretch
every resource they have in order to accommodate the demand and replace customers who upgrade to better service.
But over the next couple of years, free ISPs will face an uphill battle as to the quality of service they provide, the cost
of getting and keeping users, and the challenge of generating sufficient advertising dollars to cover costs.
Meanwhile, companies like America Online, which already has a quality discount service, Earthlink (NASDAQ:ELNK
- news) and MindSpring (NASDAQ:MSPG - news) , which will merge soon, and Excite@Home (NASDAQ:ATHM -
news) which has the largest targeted advertising database in existence, will evolve into major broadband players with
multiple revenue streams, great stickiness, competitive prices, and robust CPMs.
Where will that leave the free ISPs?
Bottom Line:
The domestic free ISP model is unproven at best, unworkable at worst. If shares of the leaders of the space, NetZero
and Juno, continue to head into the stratosphere, investors will likely wake up one day to find that the free ISP
business model is little more than a castle in the air.
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