More Doom and Gloom:
A pure-play DSL may be a pipe dream
By J.P. Vicente
Redherring.com, December 01, 2000
Broadband ISPs have clearly seen better days. The stock prices of companies like Covad Communications (Nasdaq: COVD), Northpoint Communications (Nasdaq: NPNT), Rhythms Netconnections (Nasdaq: RTHM), and New Era of Networks (Nasdaq: NEON) have plunged dramatically over the past few months on jitters about deteriorating revenues.
The fears are not unfounded. We believe investors should stay away from those stocks for now, at least until the competitive landscape becomes clearer and future revenue sources a little more predictable. If you want to play the broadband game, you should buy the chip makers as we explained in our story on Thursday.
But if you just can't help yourself and are itching to buy into ISP stocks, we recommend you stick to some big-name incumbent local-exchange carriers (ILECs). That includes firms like Verizon (NYSE: VZ), SBC Communications (NYSE: SBC), Bell South (NYSE: BLS), and, our favorite, Qwest Communications (NYSE: Q), which has become a large player in the local broadband market after its merger with US West earlier this year.
Those larger companies, Wall Street analysts and money managers say, are better positioned to withstand an expected slowdown in corporate spending next year and to deal with a shrinking pool of available credit and rising borrowing costs. Also, they add, their customer base is more solid and reliable when compared with their smaller counterparts.
"It gets to a point when you just don't think these young broadband companies will find capital to finance their business," said a money manager at a large New York investment bank who asked not to be named. "And, worse yet, their revenue streams are tainted because many of their clients, usually smaller local, privately owned ISPs, won't find capital to finance themselves either. It's a pretty bad place to be right now, from an investing perspective."
TOUGH TIMES FOR DSL PURE-PLAYS
No doubt about that. The stock prices of Covad, Northpoint, Rhythms Netconnections, and New Era of Networks have dropped, on average, a stunning 94.5 percent since March, and confidence is quickly eroding.
Rachael Rennert, an analyst at Gerard Klauer Mattison downgraded Northpoint earlier this month to Neutral from a Buy, because of concerns about the company's possible inability to collect revenue. "Until the company gains visibility into its customers' ability to pay their bills, we believe its financial future is uncertain," Ms. Rennert writes.
Making matters worse for the company, Verizon announced on Wednesday evening that it had cancelled its $800 million agreement to buy a 55 percent stake in Northpoint because of a deterioration in the high-speed access company's finances, causing the stock to plunge 70 percent on Thursday. And if that wasn't enough bad news, Moody's Investors Service, a credit rating agency, downgraded the rating of $400 million in Northpoint's senior unsecured notes due in 2010 on Thursday. The agency also placed the firm on review for further possible downgrades.
Covad said on Monday that it was cutting 400 employees -- 13 percent of its staff -- in an effort to wipe out 25 percent of its costs. On top of that, privately held DSL provider Red Connect went belly up in November, fueling fears that many other smaller ISPs may do the same.
CAN CISCO SAVE THE DAY?
The only good news for the sector this week came from Cisco Systems (Nasdaq: CSCO)'s announcement that it was offering to lend Rhythms Networks $50 million to help the firm continue with its infrastructure building plans.
But even the Cisco news got a lot of heat from critics, who say that lending to customers, while helping revenue growth, could also increase Cisco's risks of having to deal with bad debt down the line. They also say that although the extra borrowed cash may help lower the fever for ailing companies, it will not attack the cause of their illness, which is mostly the result of stiffer competition from both the ILECs and large cable providers, like Time Warner (NYSE: TWX)'s Road Runner and AT & T (NYSE: T)'s @Home, MediaOne, and TCI ventures.
Recent research by investment bank Morgan Stanley Dean Witter shows that major ILECs lead U.S. net subscriber addition to broadband access by a large margin. The bank estimates that by the first quarter of 2001, the ILECs will account for 81 percent of all net new clients of DSL, whereas the data and competitive local-exchange carriers (known as DLECs and CLECs) will share the remaining 19 percent.
So, as it stands, this market is the ILECs' to lose. Analysts say that those firms are in a prominent spot to develop a long-term relationship with the clients by offering a package of services -- which would include voice, data, and long-distance -- rather than just running the large pipes. "Companies offering a package of services will be better equipped for the new market reality. The ILECs seem to be in a good position now," says Daryl Schoolar, an analyst at Cahners In-Stat Group, a high-tech market research firm.
We believe that the distribution and service side of the broadband market is pretty crowded at this point, and you are most likely to see fewer rather than more companies in this field going forward. Because of that, the best return opportunities are likely to be in the semiconductor side of the broadband world. But, of course, somebody will have to be on the service provider side for this whole equation to make sense. And at this point, the ILECs and cable companies are winning the battle.
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