Viability of CLECs' DSL strategy questioned
This is one of the best analyses that I've seen.
By Will Wade
EE Times
(12/01/00, 4:55 p.m. EST)
SAN MATEO, Calif. — Problems at a pair of digital subscriber line companies this past week brought into sharp focus the question of whether competitive local-exchange carriers (CLECs) can survive in this market, and cast a shadow over the rollout of DSL services.
Covad Communications Inc. announced Monday (Nov. 27) that it would slash its staff by 13 percent in a wave of layoffs that are expected to cut the company's operational costs by as much as 30 percent annually. The Santa Clara, Calif., company said the move was intended to help it achieve profitability, but observers described the decision as a necessary step to stay afloat.
In addition, Verizon Communications Inc. dropped a bombshell Wednesday (Nov. 29) when it announced it would terminate a pending $800 million deal to acquire 55 percent of North Point Communications Group Inc. (San Francisco), citing the deterioration of NorthPoint's financial state.
"It now appears that none of the CLECs will be able to survive," said Tom Nolle, president of telecommunications research firm CIMI Corp. (Vorhees, N.J.). "There really is a big systemic issue with them. The problem is that there is no sensible business model for the CLECs."
These independent DSL service providers, which were among the first to offer the technology, are finding it difficult to square off against the telephone companies that are muscling into the market.
Two of the bigger CLECs, Covad and NorthPoint are both in the business of delivering DSL service using their own telecommunications equipment, housed in the telephone companies' central office sites. Because they take up space and use some of the phone company wiring, they must pay a service fee to the carriers. Their primary business model calls for wholesaling DSL service to Internet service providers, which in turn bundle it with Internet service and resell it to consumers and businesses. But sales have come under fire this year as the big voice carriers entered the fray.
The problem is fairly simple, said Pat Hurley, DSL analyst for market research firm TeleChoice Inc. (Tulsa, Okla.). Both the phone carriers and the CLECs tend to price their service at about $40 per month to the end user. Because of competition in the market, that figure is unlikely to go any higher, and will likely come down in the future, he said. The phone companies can keep the entire sum, but the CLECs must divvy up the revenue pie among themselves, their ISP partners and the phone carriers.
Unfavorable economics
"There is a cost disadvantage built in when [CLECs] are compared to the phone companies," Hurley said. "The DSL market is still very good, but their business model has not given them a chance to make any money."
The trouble at the CLECs could slow deployment of symmetric DSL services to businesses, a market that was an initial focus for the CLECs as the phone companies set their sights largely on asymmetric DSL for consumers. "The phone carriers will do their best to take up the slack, but so far they have not been very focused on the SDSL business," Hurley said.
Meanwhile, the CLECs are piling up losses. In the third quarter, Covad announced a loss of $125.3 million, on revenue of $56.3 million. NorthPoint is in similar condition, reporting a loss of $90.9 million for the third quarter on revenue of $24 million.
Both companies have been further hindered by their tight relationships with ISPs, which are themselves in dire straits and unable to pay their bills. Covad and NorthPoint were forced to restate their earnings downward last month to account for uncollected revenue, making a bad situation worse.
NorthPoint's deal with Verizon, announced in August, was seen as its ticket out of the CLEC mess. Verizon planned to use NorthPoint's existing nationwide service network as the cornerstone of its own plan to support broadband service across the United States. In fact, for all their problems, one of the CLECs' main assets remains a geographically broad network, something that all of the regional phone carriers lack.
The Verizon deal would have allowed NorthPoint to shift its business model from the standard CLEC format to something more closely resembling a subsidiary of a major carrier. That would have let it derive a higher percentage of the revenues garnered from service carried upon its equipment.
Fine print
However, the financial issues at NorthPoint made the company seem a liability, leading to Verizon's Wednesday announcement that it will exercise a clause in the deal that allows it to back out if NorthPoint's fundamentals soften. In fact, with NorthPoint shares trading in the $2 range, the company's market capitalization of approximately $266 million is well below the sum Verizon had agreed to pay for half the company.
"When the valuation started to go down, Verizon realized that it would be less expensive to develop their own DSL customer base, and paying that much money was going to make them look stupid," said CIMI's Nolle.
NorthPoint executives were taken aback by the surprise decision, and may seek to block it.
"I am stunned to get the news after months of conversation with Verizon on the strong business opportunities available to the combined entities," said Liz Fetter, president and chief executive officer at NorthPoint. "Verizon was not entitled to terminate these agreements, and we are exploring all our options, including funding options and legal remedies."
One factor has emerged that will work in favor of the CLECs. In the summer of 1999, the Federal Communications Commission issued a ruling that forced the telephone carriers to share their lines with the CLECs. Prior to this, the CLECs had to string a new copper wire from their equipment at the carriers' central office sites to the end users' homes or offices. This is completely unnecessary, because DSL technology is designed specifically to piggyback on top of voice traffic on a single copper wire, which the phone companies have already strung to nearly every building in the country.
In fact, when the phone companies offer their own DSL service, they use the existing wiring. Denying the CLECs access to these lines forced them into a weak competitive position.
The FCC decision mandating the sharing of lines means the CLECs no longer must bear the costs of installing and maintaining second lines. Matt Janiga, Internet infrastructure analyst for investment-banking firm Goldman Sachs in New York, estimated that operating a dedicated line for DSL will cost a CLEC approximately $22 per month, but using a shared line will reduce those monthly costs to $5.
While that FCC decision came last year, it is only now being implemented in the field. This is part of the reason behind Covad's staff-trimming decision, according to Chuck McMinn, the company's chairman, who said that most of the people who were let go were involved in installing and maintaining wiring. With less expenses, he hopes to push the company onto a path to profitability, which is what the financial markets are now demanding.
A year ago, striving for growth at the expense of profits was acceptable to capital managers and investors. But now, said McMinn, real profits are the only thing that matters.
Covad is also making a push to sell its services directly to end users, which is easier now that they can share lines and the service has become simpler to install. McMinn said the company's main approach now is to let users install the DSL modem themselves (or with the aid of a telephone call to a service center), and that next year he hopes to see substantially higher deployment in the consumer segment using this model.
That plan is starting to pay off. Analyst Janiga said that 60 percent of Covad's new customers in the most recently completed quarter came from the consumer segment.
While he could not specifically say when the company might turn a profit, McMinn was optimistic that demand for DSL service remains high and that line sharing will bring down costs. "We think the business is the same as it was before the market changed its mind," he said. "The demand for DSL is the same as it was, and the fundamentals of the business have not changed."
Fatal flaw
And that could be the root of the problem, said analyst Nolle, because according to his research, the CLEC business model is fatally flawed. To stay afloat, he estimated that telephone carriers and telecom service providers must see at least a 25 percent return on their capital investments. But because they must divide their revenues with other companies, the best a CLEC can hope for is 19 percent, he said. Most CLECs today are running on about a 9 percent to 14 percent return on their investments, half or less than what Nolle said they need to stay in business.
That's why share prices for Covad and NorthPoint have plunged more than 90 percent this year. This spring, Covad shares topped $65 and NorthPoint shares were trading in the mid-$30 range; both are now trading at around $2.
"As soon as Wall Street looked at the numbers, it became obvious that they weren't adding up," Nolle said. CLECs may not be able to stay solvent, he said, and with their poor financial status, they are unlikely candidates for acquisition — as the termination of the Verizon deal suggests.
"My conclusion is that the majority of the CLECs can't possibly survive," said Nolle.
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