Free ISPs dig for revenue streams: Banner ads are not the answer

Free Internet access from highly capitalized companies such as Excite@Home and the Kmart/Yahoo! partnership BlueLight.com suggest that no-charge dial-up in the U.S. is here to stay. But "free" ISP service as a viable stand-alone business is questionable.

By their own admission, free access pure plays such as Freei.Net and NetZero have yet to develop a killer business model. They don't have a prayer if they rely on the default Internet revenue generator - selling ad banner space. By 2003, according to a study by Jupiter Communications, total ad dollars booked by free ISP services will reach $901 million, only 8% of the $11.5 billion total sold.

America Online, boasting 19 million users, still derives 75% to 80% of its revenue from access fees. The company generates less than $5 per month per subscriber in advertising and other non-access revenues, Jupiter reported. Based on those metrics, Seattle-based Freei.Net, which has about 1.5 million registered users, could expect to make about $90 million annually. That sum might cover operational costs.

The 1-year-old Freei.Net has captured $35 million in venture capital so far, said Mark Grote, the company's director of marketing, and it is exploring other ways to bring in the projected 40% of its revenue that won't come from ads. Tactics include selling content space to select partners, signing tenants for an e-commerce mall and providing private label Internet access services for brick-and-mortar companies. To save on marketing costs, Freei.Net has established an affiliate program that pays Web sites $1 for every subscriber referral.

The fly in the ointment for Freei.Net is time. As it tries to get partners to ink revenue-sharing deals, it also is trying to build on its dozen points of presence across the U.S. to reduce operating costs. If Freei.Net relied on third parties for its infrastructure, its costs would be as much as $8 per user per month, Grote said.

Skimping on network buildouts is not an option because network reliability and customer service will be key concerns for free Internet access users, said John Zahurancik, vice president of broadband research for The Strategis Group. "Free services have [had] difficulty keeping service operating at a high level," he said. "[They have to] make sure the network is robust enough to handle huge spikes in capacity."

As the cost of bandwidth and infrastructure drops, free ISPs may find it easier to realize decent gross operating margins. But they also will be competing against well-heeled brand names.

Free Internet access doesn't have to be a profit center for players such as Yahoo! and Kmart, which see it as a way to drive traffic to their portal sites or stores, said Dylan Brooks, an analyst for Jupiter. "The rapid growth of free Internet access is not so much a validation of the stand-alone business model but of the value of free access as a marketing tool," Brooks said.

Indeed, Excite@Home views free dial-up as a great entry point for acquiring customers, who then migrate to its broadband services, said Vijay Krish, general manager of FreeWorld, the dial-up business unit of Excite@Home. "We are going to run this business to break even and anything above it we will reinvest in marketing." Free dial-up is a short to medium-term growth opportunity that will quickly plateau, he said.

Customer surveys by Jupiter support that assertion. By 2003, 13% of online users will access the Internet through a free ISP, according to a Jupiter study. Most users will not put up with intrusive banner ads or pay for customer service, although they may keep a free ISP account as a secondary connection.

In other words, some users may always pay for Internet access, although free or discounted plans and the migration to broadband services will put downward pricing pressure on dial-up service. The result will be more tiered offerings from big names.

"Anything that's access should be given away," said Andrew Schroepfer, vice president of equity research and senior analyst at U.S. Bancorp Piper Jaffray. To survive, service providers will have to focus on enhanced services s uch as voice mail, unified messaging, video streaming and Web hosting, he said.