Headed for a fall?

DSL wholesalers fight to remain standing DSL wholesalers are trying to rescue customers from bankrupt ISPs and adapt to the commoditization of their primary business. But whether they can keep themselves upright long enough to reverse the mistakes of the past is questionable.

One DSL wholesaler, Covad Communications, was proactively trying to stave off a financing crisis last week by unveiling a plan to reduce cash outflows and capital expenses and target higher margin business accounts. The plan outlined by new interim CEO Frank Marshall and Chairman Chuck McMinn caps the provider's central office buildout at 2000, ceases line installations for ISPs that are delinquent in payment, restricts residential orders to line-sharing and self installations, and cuts co-marketing spending with ISP partners.

"We have built a national network very quickly [that is] lightly loaded," McMinn said. "To reach profitability, we need to stop expanding our network and load what we have built. We can't simply cut our network to profitability."

But McMinn also wants to be more selective with channel partners and end users to reduce Covad's customer acquisitions costs.

"Every user we add to the network requires an investment," McMinn said. "The price we charge for installation does not fully cover the cost. In the past, we relied on external capital sources to fund both a rapid expansion of the network and a rapid acquisition of customers. Going forward, we're going to change those priorities."

But Covad and its competitors, NorthPoint Communications and Rhythms NetConnections, may struggle just to retain their existing customer bases. Four of Covad's ISP resellers representing 65,000 lines in service are bankrupt: Flashcom, Zyan Communications, Relay Point and Fastpoint. Another 32% of Covad customers, or 80,000 lines, are serviced by "at-risk" ISPs - those that have paid their bills but whose long-term financial viability is in question.

Covad is in the process of switching customers of the bankrupt ISPs to more stable ISPs or to its proprietary ISP service. Meanwhile, Rhythms is switching its residential lines served by Flashcom to EarthLink, and NorthPoint is doing the same with Telocity.

Having too many ISP partners resell DSL may have been one of the key mistakes of the data competitive local exchange carriers (CLECs), said Patrick Hurley, DSL analyst at TeleChoice. "They didn't have stringent enough requirements for the financial health of their business partners," he said.

Covad expects to spend $200 million less cash in 2001 because of its revised business plan, hoping to survive on the $900 million in cash it has until the fourth quarter of 2001. The company's objective is to reduce its monthly cash-burn rate from about $75 million in the fourth quarter of 2000 to less than $60 million by the end of 2001.

Although it's a step forward, Covad's plan still is subject to substantial execution and funding risks, said David Bank, telecom equity analyst at RBC Dominion Securities. Migrating the 65,000 lines from "financially troubled" ISPs could become more complicated as these ISPs "slip into bankruptcy," Bank said. In addition, Covad has yet to provision DSL over shared lines on a mass scale or gauge the receptivity of consumers to self-install kits, he added.

According to a report by Matthew Janiga, analyst at Goldman Sachs, Covad will need an additional $1.5 billion in capital when its current funding runs out. Covad said last week that it plans to reach EBITDA break even in the fourth quarter of 2002 - a year earlier than previous projections - but Janiga said that timetable appears very aggressive.

"To improve EBITDA by $20 million a quarter beginning in 2001 and throughout 2002, we estimate that Covad would have to more than double gross margins," Janiga said.

Like Covad, Rhythms and NorthPoint are desperately seeking funding as their stocks linger at levels that create the prospect they could be delisted from the Nasdaq. After Verizon Communications pulled out of its $800 million merger agreement with NorthPoint - taking $200 million in interim financing with it - NorthPoint says only that it is exploring all options and that no additional funding is imminent.

As of Sept. 30, NorthPoint had cash and cash equivalents totaling about $150 million - enough to get it to the middle of 2001, according to analysts. Meanwhile, Rhythms had $748 million in cash, investments and restricted cash, which it says will fund operational needs through the end of 2001.

Data CLECs will need to convince potential investors they can recover from the commoditization of the DSL transport business, Hurley said.

Because the incumbent carriers have an inherent cost advantage at low price levels, data CLECs should concentrate on differentiators such as robust service level agreements and value-added services such as virtual private networks, managed security services and even voice, Hurley said.

"Voice over DSL has really gone nowhere this year," Hurley said. "But it's still an application that makes a ton of sense for small businesses."