If you can't beat 'em, join 'em

Will data CLECs be forced to turn to incumbents to survive? As turmoil in the DSL service provider space intensifies, data competitive local exchange carriers such as Covad Communications, NorthPoint Communications, Rhythms Net-Connections and others find themselves in an odd position. Instead of looking at incumbents as the competition and battling them for customers, data CLECs are instead looking at the RBOCs in a new light.

With Verizon Communications' $150 million cash investment in NorthPoint and SBC Communications' investment of the same size in Covad, data CLECs find themselves more dependent on their competitors than they ever expected.

But so far the investments have not been a saving grace for either Covad or NorthPoint. Wall Street's dour reaction to the DSL market lately sent Covad's stock plunging to less than $4, while NorthPoint's shares sunk below $5 and Rhythms' dove below $2. And on Nov. 1, Covad's troubles forced the resignation of President, Chairman and CEO Robert Know-ling.

Although the financial markets aren't reacting as data CLECs would hope, demand for DSL is still strong. According to Cahners In-Stat Group, the number of DSL subscribers will hit 23 million four years from now, with North America leading the charge. And despite competition from data CLECs, RBOCs are pulling ahead in terms of DSL subscribers served.

With massive initiatives such as SBC's Project Pronto, under which SBC is spending $6 billion on DSL deployment, it's no wonder that data CLECs are having difficulty catching up. And thanks to Wall Street's skittish behavior, venture capital is drying up. Massive undertakings such as Project Pronto are beyond the reach of data CLECs, and some may cease to exist based on their faulty business plans, said David Solomon, chairman and CEO of Gabriel Communications. Gabriel recently acquired TriVergent Communications to provide voice and DSL services to businesses throughout 13 Midwestern and Southwestern states.

During the next year, there will be many mergers and acquisitions in the DSL space, in addition to companies having to sell off into "piece parts," Solomon said. "Some businesses launched into business plans as if capital was free-floating."

Verizon's purchase of a controlling stake in NorthPoint is a classic example of what will probably become a necessity for data CLECs to survive. "There's a general view that the market is going to evolve over time," said Jeff Thompson, executive director of marketing strategy for NorthPoint. "We may not see stand-alone data CLECs like we see today."

Initially, data CLECs entered the market by serving small and medium-sized businesses, where they didn't compete directly with incumbent LECs (ILECs). "As line sharing and the adoption of DSL became easier, it became more viable for independents like NorthPoint to enter the residential space and compete head-to-head with ILECs and cable providers," Thompson said. This is where the trouble started. In the residential space, the economics are more critical because of thin margins and scale, he said.

For NorthPoint to scale to keep up with the likes of SBC - which by the end of the third quarter already had rolled out 516,000 lines - the Verizon partnership was important, Thompson said. "To provision DSL, there needs to be a lot of coordination," he said. "You need to build a relationship with the incumbents."

For an incumbent, these acquisitions, partnerships and mergers also will have an advantage, said Mike Lowe, senior industry analyst of advanced carrier strategies for Cahners In-Stat Group. Under the guise of a data CLEC, an incumbent can compete out of region without regulatory limitations, he said. But the mergers will not be without scrutiny. The Pennsylvania State Public Utility Commission already is looking into forcing Verizon into the wholesale business, he added.

Currently the entire DSL business is really about owning the network and owning the customer, Lowe said. If the RBOC doesn't own the data network, it can't get access to the customer, whereas a data CLEC might own a network but have a hard time getting access to the customer."It's a tricky situation on both sides," he said. "Not owning the customer is bad. Money is good." In the case of NorthPoint, the data CLEC is insulated now because of the Verizon deal."Having access to the RBOC's residential customer base is huge," Lowe added.

Besides owning customers and owning a network, the data CLECs also must begin to offer services directly to customers rather than rely on the wholesale model, Lowe said. "The wholesale model is flawed," he said. "Covad is exploring the direct sales model, and it might be their saving grace."

While NorthPoint may have built itself on the wholesale model initially, Thompson concedes that the model does "get tricky" when it comes to the economics of sharing a finite amount of money with a number of providers.

Going directly to customers with value-added services will be key for data CLECs in the next year, said Eric Moyer, director of product marketing for Covad. Typical services will include voice over DSL, Web hosting, e-mail accounts, firewalls, virtual private networks and private networks - all services beyond high-speed Internet access, he said.

Once customers get a fast connection to the Internet and have a much better experience than with their dial-up connection, the question is what to do next, Thompson said. "Voice over DSL is a great example of value-added services because it means [enabling] a more compelling offer to a broader set of customers," he added.

So what's in store for data CLECs and RBOCs on the DSL front in the next year? Competition will become less focused on the ILECs vs. data CLECs battle, Thompson predicted. Instead, service providers such as cable providers and AT&T, which revealed that it would enter the DSL service provider market when it announced its four-way split, will step into the picture, he said.