Internet: High Speed Bump: Is There Hope for DSL
Providers?
By: Eliot Walsh (07/31/00)
Shares of the major Digital Subscriber Line (DSL) service providers, which offer high-speed Internet access over regular phone
lines, have been sliding for months.
Industry leaders Covad (NASDAQ: COVD - news), Rhythms Net Connections (NASDAQ: RTHM - news) and NorthPoint
(NASDAQ: NPNT - news) are all off about 72% from their 52-week highs. Across the board, costs are outpacing revenue,
competition is getting stiffer and DSL prices are dropping.
Yet analysts following all three companies profess a bullish future. Why?
Otherwise known as Data Local Exchange Carriers, or DLECs, the group is set to average about 35% sequential revenue growth,
according to a recent report from Jefferies & Co. analyst Joseph Bellace.
But concerns abound that the costs of implementing such growth could put DLECs at a disadvantage relative to the Regional
Bell Operating Companies, with whom they compete. Meanwhile, they are fighting the cable companies and their high-speed
cable modems on another front.
In fact, some camps maintain that, in the longer term, DSL technology may become an endangered species as fiber optics
gradually replaces copper throughout the public telecommunications network.
Last week, when independent DLEC Covad Communications announced second quarter results after last Wednesday's closing
bell, analysts and investors cheered the company's better-than-expected 39% sequential revenue growth and narrower-than
expected loss. The company said sales grew to $58.2 million from $10.8 million a year ago and $41.8 million in the first quarter.
Meanwhile, the company lost $131.5 million, or $0.86 a share, compared with a loss of $41.9 million, or $0.61 per share a year ago
(shares outstanding increased to 153.4 million fr0m 68.2 million in the same period). First Call analyst consensus estimates had
forecast a loss of $1 per share for the second quarter.
Company (Ticker) 52-Week
High Price
July 28 Decline
From
52-Week High Rhythms Net Connections (RTHM)$50$1276% Covad (COVD)$66.67$16.5675% NorthPoint (NPNT)$39.13
$10.7573%
While widening losses and quadrupling costs may not look like positive signs for the company, investors nonetheless bid shares
of Covad up $1.06 to $18.75 Thursday morning, before the overall Nasdaq market dropped 145 points and erased the stock's
gains. And Covad's financial state is not unique in the industry; two of its biggest competitors, NorthPoint and Rhythms Net
Connections are in the same boat.
Rhythms, which announced second-quarter results last Tuesday after the closing bell, posted a per-share loss of $2 compared to a
loss of $1.63 in the previous quarter, and a loss of $0.68 in the year-ago period. Sure, sales increased more than sevenfold to
$12.2 million from $1.6 million year-over-year, and DSL connections rose 10-fold to 31,000. But, like Covad, spending increased
dramatically. Overall, the company increased capital expenditures on its network and service to $51 million from $12 million in last
year's quarter.
NorthPoint plans to announce its second-quarter results on Tuesday, August 8. First Call estimates a loss of $0.85 per share,
compared to a loss of $0.62 in the previous quarter and a loss of $0.44 in the same year-ago quarter, and capital expenditures are
reasonably expected to be huge.
That all of these companies are losing lots of money hasn't been lost on investors. The stock prices say it all: Covad is trading at
$18.13, down from a 52-week high of $66.67, Rhythms trades at $13.81, down from $50, and NorthPoint has fallen to $10.50, just
above its 52-week low, from $39.13.
Still, all 16 analysts who registered stock opinions with Bloomberg rate Covad at least a ``buy.'' About 78% rate Rhythms a
``buy,'' and 71% recommend NorthPoint. However, none of them thinks any of these companies is about to turn profitable.
The reason they like DLECs is that they believe DSL technology will become ubiquitous within a few years. Analyst Daniel Ernst
of Legg Mason compares this general investment thesis to that of wireless phone service in its early days. ``You have to invest a
lot of money to build up these services,'' he says, ``and whereas wireless started 10 years ago, DSL is like a year old; we're just in
the first inning.''
He acknowledges that broadband prices per unit will probably come down, and that huge capital expenditures will continue for
the foreseeable future, as they have in the wireless sector. He also admits that the question of earnings isn't likely to be answered
soon.
``Covad is EBITDA positive in three markets right now,'' Ernst figures, ``and if they stopped building now, they could probably
be EBITDA positive in all of their markets.'' But that's not a good way to leverage the business, he maintains. The companies must
keep growing until DSL is a fact of life for a sufficiently large proportion of businesses and consumers. ``The issue of profitability
over the long run is not an issue right now,'' he says.
Maintaining the solid execution of their build-outs, as measured in subscriber and revenue growth, should help re-ignite the
stocks, says Ernst. ``It doesn't look like second-quarter results are going to do it,'' he jokes.
Indeed investor sentiment has lagged steadily since the companies' IPOs not long ago. ``People expected a lot out of the box,''
Ernst notes. But, as has been the case across the broadband sector, the reality has been that providing broadband service takes a
lot of time and money before it makes its way into businesses and people's homes. As that notion has sunk in, the overall market
simultaneously has lost its exuberance, and investors seem to have lost their enthusiasm for stocks valued primarily on long-term
potential.
But unlike, say, many Internet stocks, DLECs have been building tangible assets and have clear revenue models as well as clearly
defined costs. Ernst figures broader bullish sentiment will return to the sector as DSL service becomes more and more visible in
daily life, which should illustrate for many the potential growth of the industry.
``When cell phones first came out, people said, 'no they're too expensive. I don't need one unless the company pays for it.' Then,
in 1995 people were saying, 'Okay I'll buy one but keep it in my glove compartment just in case.' Then, by 1999, everyone was
using a cell phone.''
An acquisition of one of these DLECs would bode well for the group, too, he says. Already Covad is one on the largest providers
of DSL service to AT&T (NYSE: T - news) , which recently said it would ramp up its DSL services.
Ernst believes the stocks will start a recovery in the third quarter, as acceptance grows among consumers and businesses. A
widely held tenet of the broadband industry is that a ``virtuous cycle'' exists wherein an increasing number of available
broadband applications drives demand for broadband services, which then drives demand for still more broadband applications,
and so on.
Ernst doesn't see the ascendance of optical networks as posing a threat any time soon, considering the sheer size of the task of
replacing a predominantly copper-based telecommunications network that took 100 years to build. ``Will DSL be around in 10
years? Sure. Will it be in the exact same form as it is today, probably not,'' he says.
``I think the wind will return for these stocks,'' says Ernst, ``but there will always be volatility. Some new technology will come
out, and investors might be nervous about it for a while. But in the long-run, DSL will the only way for many people to get
broadband Internet access.''
However, the big question is whether the DLECs will be around as independent companies. Given their capital needs and the
competitive pressures, their best bet in the end may be to find a partner and sell out. Afterall, they are probably cheaper targets
than the cable companies.
Bottom Line:
Investing in DLECs takes some faith that broadband connections to the Internet will become the norm in the near future-a
probability in the eyes of most technology watchers. Owning DLEC stocks now could pay off mightily as that vision becomes a
more obvious reality. But investors should be aware that volatility will follow these stocks for years to come, and that these
companies will all have to spend huge sums before they turn profitable.
For more in-house professional stock analysis and commentary, visit us at Individual Investor Online.
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More Quotes
and News:
AT&T Corp (NYSE:T - news)
Covad Communication Group Inc (NasdaqNM:COVD - news)
NorthPoint Communications Group Inc (NasdaqNM:NPNT - news)
Rhythms NetConnections Inc (NasdaqNM:RTHM - news)
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