DSL Providers Facing Tough Times

In recent times, providing DSL access is like feeding the mouth that takes a bite out of profits. Instead, try changing your ISPs business plan and take a bite out of the market.

by Jim Thompson [January 5, 2001]

While subscribers rush to embrace high-speed access for both home and workplace Internet connections, several ISPs—and the companies that supply DSL connections—are facing diminished returns and in some cases, bankruptcy.

Happy times
"There is no question that DSL is a lot more expensive and lot more difficult to roll out than most ISPs originally thought and that's their biggest challenge," said Daryl Schoolar, industry analyst for ISP strategy at Cahners In-Stat Group.

"At the same time, we forecast strong growth for the market on both the enterprise and consumer side," Schoolar added.

On the surface, it would seem to be the best of times for ISPs that support DSL services. More than 1.2 million DSL connections are already in use and demand is growing daily. According to Jupiter Media Metrix, the number of DSL connections is expected to grow to nearly 7 million lines in use by 2003 and more than 12 million lines in just four years.

Most ISPs report that they're having a hard time keeping up with consumer demand for high-speed access to the Internet. In some cases, residential customers report having to wait months to get a DSL line installed.

Mean times
At the same time, a number of high-profile service providers are facing financial difficulties. Wholesale DSL provider Covad Communications was one of the first firms to hint that it was facing financial difficulties when it made staff cuts and lowered its anticipated quarterly report. Covad executives said that much of its financial distress was the result of ISP customers defaulting on payments for DSL connectivity.

Verizon Communications recently terminated its merger agreement with NorthPoint Communications, citing the DSL provider's diminishing financial disposition as a reason to nix the merger.

In a statement, a Verizon spokesperson said, "NorthPoint recently reported a continuing decline in revenues, an erosion of its customer base, an increase in expenses due to write-offs for increased bad debt, and as a result, a material increase in net losses."

Things have not gone well for NorthPoint since August when the two companies announced their plan to form a national high-speed Internet company. Initially, NorthPoint stock hit an all time high of $38 per share, although it has dipped below the $1 mark in recent days. NorthPoint also revised its third-quarter revenue estimates downward from $30 million to $24 million. Like Covad, chief executives pointed toward customer payment problems as one of the major reasons for the glum forecast.

Currently, both Verizon and NorthPoint have filed and counter filed lawsuits against each other over terminating their proposed merger.

In November, New Edge Networks laid off of more than 130 workers. A number of ISPs followed suit and publicly discussed experiencing financial difficulties. Among them was PSINet, which is reportedly exploring "a strategic alliance or the possible sale of all or a portion" its business. Meanwhile, Flashcom, Zyan Communications and RelayPoint have all filed for Chapter 11 bankruptcy protection.

Borrowed time
If the market and consumer demand is growing, why are ISPs and CLECs reporting fiscal problems? What happened to the old theory of supply and demand? How can companies post a loss at a time when sales are surging?

The answer seems lie in a combination of factors. First, competition is growing among smaller ISPs for DSL customers. Second, some DSL-based business embraced poor business practices resulting in increased costs and lower profit margins. Third, the Baby Bells chimed in on DSL services and further increased competitive pressure on local ISPs.

There has been tremendous growth in the ISP space over the last few years. Most service providers are small—but all are hungry for business. With hundreds of small ISPs slugging it out for their share of business in a particular market, it only stands to reason that some businesses would fail.

In-Stat's Schoolar said overall, the number of ISPs entering the market is growing at a faster rate than actual revenues for Internet services.

"We're seeing now that the average revenue for an ISP is shrinking because of the increased competition," Schoolar said. "That's really scary for these guys trying to get into DSL at this time. Yet, its like a Catch-22, how are they going to survive without getting into DSL?"

Added to competitive market pressure for independent ISPs, is pricing pressure from the regional Baby Bells, driving slim profit margins down even further. After ignoring DSL for several years, the ILECs have finally awakened from their slumber to realize that it is a desirable high-speed service to provide.

The Baby Bell companies are aggressively attacking a marketplace that, for many smaller companies, holds little potential for profits.

"The local Bells can go longer with smaller profit margins," noted Schoolar. "Their whole business model doesn't rely just on being successful with DSL. My call waiting can help pay for DSL. That's a luxury a lot of the ISPs don't have."

Although the technology is changing rapidly, DSL remains difficult and costly to provision and install. Increased competition has forced the cost of DSL down to the $40-per-month range. At this price, an ISP makes about $10 or less—and much of this is eaten up by increased hardware costs required to support additional customers.

Advertising and marketing costs represent a further financial drain on ISPs eager to attract new customers. As any ISP owner can tell you, without an effective advertising campaign in place, there's no hope of surviving in such a competitive environment.

Time lapse
Some analysts believe the DSL demise simply happened too fast. When DSL first hit the scene, ISPs were quick to begin offering the service.

Everything seemed in perfect harmony—the stock market was reaching an all time high and companies with remote ties to the Internet were eagerly sought out by investors. Venture capitalists were fighting to give dot-com startups buckets of cash, and all was right with the ISP and CLEC worlds.

As quickly as DSL access providers materialized—the market began to unravel.

First, stock prices hit the skids, then venture capital dried up, finally investors we fed up and demanded profits rather than market potential or subscriber growth. As a result, many broadband-based companies currently find themselves unable to raise the capital necessary to build a profitable future.

Prime time
Other analysts believe that we are witnessing a consolidation of the industry and that only the strongest and largest DSL providers will survive.

So what's a poor, small, independent ISP owner to do? How can they persevere in this dog-eat-dog DSL economy?

Schoolar believes there is a way to survive current market trends. He said ISPs would have to start thinking of themselves as communications companies, not just Internet companies.

"The real secret is to diversify," Schoolar said. "ISPs have to look at things like application hosting, Web hosting and other complementary communication services in order to survive."

If your looking to turn a profit on DSL access anytime soon, start looking toward bundling high-speed access with value-added services for both home and office clients alike.

—End