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DSL Prime News Weekly: The DSL Drama

"It just keeps getting uglier and uglier,"
— Ken Hoexter of Merrill Lynch on Covad's problems (WSJ)

What the heck is going on at Covad?
"We are in no danger of Chapter 11 at all" Covad's Sessums
Chuck McMinn and team built an exciting company, but this second financial crisis implies a tough road ahead. Covad's writing off at least another $50M—and probably much more—when they finish closing their books this quarter. Part of the writeoff is an accounting rule (if a modem is provided as part of a three year contract, the modem income has to be spread over three years.) Another part is marketing funds advanced to ISPs that have not paid off, and a large part is additional ISP debt, most of which we thought had been dealt with months ago.

They are closing 300 of 1900 COs, extending layoffs, and returning trucks to the lessor. They are essentially writing off much of the Bluestar deal. A few days earlier, Covad played hardball with ISPs, shutting off thousand of customers of Internet Express and DSL Networks, creating permanent fear among customers, terrible pr, and convincing us, before the financial announcement, that the problems were much worse than reported.

If Bob Knowling hadn't pushed through the last $500M financing just before he left, the situation would be dire; with the cash on hand, Covad has many months to turn things around, and we hope they do. Fortunately, AT&T, XO, SBC, and others able to pay their bills are bringing in most of the new customers, and Covad reached a businesslike settlement with Flashcom in court. Below, some Covad good news (linesharing is working, and customer self-installs are increasing), and next issues we have an interview with ex-CEO Bob Knowling. (Sorry, no revelations—he continues to like and respect the people he worked with at Covad.)

NorthPoint for sale
Bids coming in for late March
Verizon suit advancing
There are many rumors—but little solid information—about the bidders for NorthPoint, in a process leading up to a court date in late March, the hoped for (but not guaranteed) final resolution. One probably out of the running is NTT/Verio, which is pulling away from DSL. (Will NTT have to take a write-off on their $5.5B purchase of Verio, now clearly worth less than half that?)

Meanwhile, they've won a ruling that their $B plus law suit against Verizon can proceed in California, and recent events have only improved their case. NorthPoint should win the suit if the "material adverse events" were caused by "facts, events, changes or effects that are generally applicable to (A) the data industry, (B) the United States economy or (C) the United States securities markets generally or the Nasdaq Technology Index in particular". Clearly, problems in the data industry played a major role. Lucent, Cisco, and Nortel have also suffered shortfalls that NorthPoint's lawyers will attribute to "problems in the data industry"—an argument whose merits may well remain unclear until years from now in a jury trial.

Meanwhile, we're watching Verizon's financial statements. They presumably will have a lawyer's opinion that minimizes their material risk, but the lawyers we've consulted are not sure at all, and a reserve (or a settlement) would be prudent.

Nortel cutbacks—we got the story right by accident
"CLEC strategy" failed, as Nortel's layoffs demonstrate
We were just referring to DSLAM future sales, but several misread our comment suggesting deeper Nortel trouble, which we were not predicting. We have enough trouble tracking DSL. Turns out, the same reasoning applied to the larger company as well, but we hadn't predicted it.

John Roth of Nortel is a smart and honest man, who has earned the industry's respect. We believed him when he told five hundred wall streeters that Nortel would have an exceptional 2001, growing 30%. Last Thursday, he had to accept that he was wrong, and laid off 10,000 employees. The fall speech itself contained enough to anticipate the problems, as we now see in hindsight. He emphasized sales to CLECs, but told us Nortel would no longer finance them. Since CLECs worldwide are short of capital, he was being unrealistic expecting major growth. Apparently also unrealistic were his growth goals for optical networking, the one area the bubble hadn't burst in. Nortel is the last of the telecom giants to accept the problems, which originate in the capital expense cutbacks at telcos around the world.

Corporate problems, unfortunately, overshadow the remarkable fourth quarter of 2000, and Nortel has now shipped over 600,000 lines of the Promatory DSLAM. Korea Telecom has become a major customer, and they are also shipping to @Link, First Mark, and PLDT in the Philipines. Tokyo Metallic gives them an enormous upside in Japan. Brett Sheppard believes they had 10% of the world market last quarter, and will hold or increase that percentage this year.

What Wall Street knows about telecom equipment
For the last six months, Wall Street has seen projections from telco after telco that capital spending will be relatively flat or down for 2001 and 2002. Qwest, Verizon, SBC (and of course all the competitors) geared up for data and wireless, and are unwilling to up the rate of investment. The result, of course, is that equipment sales, especially in the US, also cannot rise rapidly. While individual companies may buck the trend, it was impossible for most major companies to increase sales 20-30%, as many hoped. One by one, sales projections have come down, from Lucent, Cisco, ADC, and now Nortel. Most were inevitable—you can't sell what they won't buy.

Covad: making line-sharing work
In nearly 100% of 1600 surviving offices
Linesharing cuts monthly line costs from $10-20 to about $3, and is absolutely essential if there is ever to be any competition for consumer DSL. The FCC ordered it for last June, and after delays it is working well in much of the country, with lines delivered to competitors in less than 5 days in many cases. Because it uses existing lines the problem rate is as much as 70% lower, dramatically driving down the operational cost.

Covad hoped to be this far along in December, but some areas dragged to February. As they train ISPs and restructure agreements, they are also moving to standard customer install for nearly all consumer sales this spring. These kinds of day-to-day improvements mean the industry's longterm future is bright—despite the painful stories we have to report.

ConnectSouth: another one bites the dust
Staff gone, operations expected to close
"Another one bites the dust" is our headline, to make the point that industry problems are overwhelming many companies with decent management and hard-working staff. We know the pain of the people whose dreams were denied is very real; some will lose their homes and health insurance. Good companies, not just weak ones, fail in this market, and everyone looks for a scapegoat. But Bob Knowling of Covad, for example, was not a brilliant manager in April and a rube in October. Rather, he was a smart man brought down by industry changes. He's happy to talk, with hindsight, about mistakes he made—but we've yet to meet anyone perfect.

Morgan Stanley funded CLECs in different regions, hoping to duplicate the remarkable early success of Rhythms, Covad, NorthPoint, and DSL.net. eAccess in Japan is now growing rapidly, and we hope proves a prudent investment. But nearly a half dozen groups had a similar idea in the US south and southwest, and the result is that all are in trouble. Before the general CLEC collapse, Bluestar's IPO failed and their VCs were temporarily bailed out by Covad (another portfolio company). Vectris and Darwin followed, and now ConnectSouth, when the next round of funding fell through.

New Edge: we're cutting back
55 jobs lost
Dan Moffat's company is pegged as one of the survivors, but that means he has to make tough decisions along the way. With no more capital in sight, he had to drop 55 more workers (second layoff) as well as temporarily shut down some locations in Florida and Georgia, reducing COs to 500. He's also had to turn down very attractive offers to take over others, including Vitts and ConnectSouth; a very smart banker should find a way to provide him the funding to take advantage of opportunities like that.

In the works is an editorial "Seven realistic steps to increase competition, bring down prices and move toward universal service" One of them will be to bring the price of fiber backbone connections down in rural areas, the main reason Covad, New Edge, and others are shutting down small offices. The marginal cost of a fiber-optic lambda is dramatically less than the fees charged; if there is no competition, then creative unbundling or regulation should be used to reduce monopoly-like prices. Congressmen Tauzin, can you deliver that to your small town constituents?

Copyright 2001 Dave Burstein.
The DSL Prime Newsletter is reprinted with permission.

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