Jan 22, 2001 12:00 PM,

Weathering the perfect Storm

by Ken Branson

As data CLECs seem to be falling and folding, the industry is divided over whether they will survive

Data CLECs are dead

The first sign of approaching mortality, some observers say, is anemia. Money, the lifeblood of any business, and especially to capital-intensive ones such as data CLECs, is drying up no matter where you look.

The customers of some data CLECs have been unable to pay their bills, and this problem is what caused Covad and NorthPoint to restate their third quarter earnings.

In Covad's case, the restatement was tied to 14 ISPs, mainly “silver-” and “bronze-” level customers. Those ISPs, analysts say, couldn't get capital to fund their operations. Covad's difficulty in collecting from them led to a downward adjustment of its EBITDA to -$125.3 million from the original -$120.4 million.

In NorthPoint's case, the news that 27,000 lines (31% of its installed customer base) were served by delinquent ISPs was enough to get Verizon to pull the plug on its agreement to merge its own DSL business with NorthPoint's and to take an $800 million, 55% stake in the San Francisco-based data CLEC. Verizon cited the “material adverse conditions” clause of its agreement with NorthPoint in backing out.

NorthPoint officials did not respond to a Telephony request for an interview.

The news about NorthPoint and Covad could not have come at a worse time for data CLECs. The same capital markets closing to their ISP customers also were closing to them. This was true up and down the size spectrum.

Covad has announced sharp cutbacks in its national and international expansion because it can't find the capital to continue. Network Access Services has decided to remain a regional data CLEC. HarvardNet, according to a spokeswoman, largely based its decision to get out of the DSL business on the scarcity of capital.

Another source of money, the stock market, has all but flat-lined. To some extent, the stock market's treatment of data CLEC stock reflects the general flight from technology stocks of any kind, but it also reflects concern about the basic business plan of many data CLECs.

Moore of Current Analysis, for example, believes that data CLECs have just been outgunned—basically, outspent—by RBOCs on the national level. RBOCs have had more money to spend on everything from advertising to technology, and their numbers show it: SBC has 516,000 access lines; Verizon, 350,000; Qwest Communications, 213,000; BellSouth, 134,000. Covad has 250,000 access lines nationwide but has virtually stopped its rollout.

The other data CLECs show much more modest numbers: NorthPoint has 87,300 access lines, and the entire data CLEC sector amounts to about 500,000 lines. In addition, ILECs have beaten data CLECs' margins into the ground with aggressive pricing and discounts.

The whole idea of selling DSL is dead, Moore says, and so is any company that clings to it. “DSL is a means to an end and not the end,” he says. “That's the ballgame for these guys. What they need to do is reposition themselves and successfully sell themselves in the marketplace.”

What data CLECs have to sell are value-added services, and many of them are doing just that. But it may be easier to say than to do. The data CLECs, after all, have spent the past two years marketing themselves as providers of high-speed Internet access, either directly or through channel partners.

Many data CLECs burned their bridges early by not coming to terms with ILECs, says Taher Bouzayen, director of broadband markets at Boston-based Atlantic-ACM.

“After all, the main business of data CLECs is the local loop, and if you can't find compromise with the masters of the local loop, you can't do anything,” Bouzayen says. “They were banking on the FCC, and they really wanted to compete with Verizon, SBC, etc., on their territories. And the RBOCs made their lives hell. Well, you'd expect it.”

This failure to make nice with “the masters of the local loop” is the key to the data CLEC's problems, Bouzayen says. Failure to make nice led to RBOCs dragging their feet on provisioning and interconnection issues, which led to service problems, which led to word getting around.

“[The data CLECs'] customers will run away from you,” he says. “You will lose credibility. If you lose credibility in L.A. and San Francisco, by the time you go to Boston, their credibility has already sunk.”

Not dead yet

Covad spokespeople point out that, stock price or no stock price, restatement or no restatement, slowdown or no slowdown, 250,000 access lines are still 250,000 access lines. And Charles McMinn, the once and current chairman of Covad, says there's nothing wrong with the business plan, thank you very much.

“The demand continues to be the same or growing on a quarterly basis for these lines,” McMinn says. “We're about 5% to 10% penetrated.… What we need to do is shift from a model that says grow… to one that says, grow more slowly but get to profitability more quickly.”

Some analysts agree—cautiously. Greg Mycio, telecom analyst at New Paradigm Resources Group, says Covad's market share (as measured by access lines) and what he sees as its improved operations support systems (OSSs) may just save the day.

“With regard to Covad, their problems come down to provisioning, and with their better OSS, which they've just gotten up to speed, and some luck on the receivable side, they've got a 50/50 shot,” Mycio says. Mycio and others also cite SBC's investment in and alliance with Covad as a plus for the Santa Clara, Calif.-based data CLEC.

Covad has made the right moves to meet the current crisis—downsizing, slowing down the rollout and working on the OSS issues, Bouzayen says. But he thinks that data CLECs need to go further than that.

“They need to review all their market penetration strategies,” Bouzayen says. “They will need to focus on the most lucrative markets. [Data CLECs] don't have enough cash to do it nationwide.”

While many analysts think data CLECs will have to find some sort of niche—geographic, technical or demographic—in which they can shine, McMinn says that Covad is not going there.

“I don't really see it that way,” McMinn says. “Everybody has to have a core competence, but to say we have to find a place where they're not is not really sound.” The ILECs are only in their own regions, he notes. “We have a national footprint.… To the extent that our niche is the nation, [ILECs] are not competing at all. And they're not focused on the small business market.”

Of course, the ILECs are growing beyond their own regions as they receive Section 271 approval. Covad's own agreement with SBC, in which the ILEC took a 6% stake in Covad and awarded Covad a $600 million contract for DSL services, is still good, McMinn says, adding that he has had no nervous phone calls from SBC. After all, SBC is under federal mandate to enter 30 markets outside its traditional region this year, so why would the carrier end its relationship with Covad?

Verizon, also eager to move into new territory, also must look at means of expanding beyond its traditional territory; analysts expect Verizon to make some move to fill the hole in its strategy that was to have been filled by NorthPoint. People such as McMinn believe that ILECs might need data CLECs in the near future. That need, combined with an abysmal stock price, works against many data CLECs getting bought, McMinn says.

“We think our value to the industry as a whole is much greater as an independent entity,” he says. “If we were bought by an ILEC or an IXC, the others would not want to do business with us. Our whole value to them is that we don't give a competitive advantage to one over the other.”

Jon Aust, chairman and CEO of NAS, sees his company's situation the same way. While he concedes that the ILECs have won the war for residential DSL business, he thinks independent data CLECs can survive if they just hang on.

“We've got the infrastructure in the ground and a company that's operating,” he says. “We've taken cash requirements to the bare minimum… so we can survive while other companies hit the rocks, and our value only increases.”

NAS, in addition to laying off 145 people (23% of its work force), is focusing on what Aust calls “the wide range of the middle [business] market and selected large businesses” in the northeast corridor. The company will focus on customers with at least 100 employees and three locations.

Finally, Cisco Systems, which earlier lent about $75 million to Rhythms, offered to lend the Denver-based data CLEC another $50 million. A Cisco spokeswoman declined to comment.

Some analysts think this loan is a sign of weakness on Cisco's part. Loan someone $1000, and you own him; loan him $50 million, and he owns you. Rhythms officials, however, point to the loan as a vote of confidence in their company.

We're different

Rhythms CEO, chairman and founder Catherine Hapka concedes that these are rough times for data CLECs but insists that her company will weather the storm.

“I would describe it as the ‘Perfect Storm,’” she says, borrowing from the movie in which her part is played by George Clooney. “We've had a meltdown in the Nasdaq. Within that, telecommunications carriers—because they're huge infrastructure businesses and require a lot of capital—have suffered. And then there's a sort of triple witching: DSL providers have suffered because some of the providers didn't meet analysts' projections; we, unfortunately, have gotten the flu along with them. The Nasdaq is down 150 points—it's ugly out there.”

But Hapka is holding her course. True, she concedes, a lot of boats will go down, but not Rhythms. Mention the restatements of third quarter earnings by Covad and NorthPoint, and Hapka insists that Rhythms is different.

“We have a very different customer base, broader and much more diverse,” Hapka says. “We have not restated our third quarter numbers. We felt our reserves for revenue have been sufficient.”

In addition, Rhythms recently announced that Flashcom, one of the ISPs that had trouble paying its bills to Covad, agreed to move its traffic to another carrier, Telocity. Company officials stress that only 11% of the $17.2 million in revenues they reported in the third quarter is from consumer business.

McMinn and his colleagues also maintain that things at Covad are different.

“In the first half of the year, the markets valued one thing above all things, and that was growth,” he says. “Whether you were an ISP or whatever, growth was the top metric—growth in eyeballs, growth in revenues, growth—in our case—in line count. About the third quarter, they decided that the correct metric was profitability and began to discount companies that weren't profitable or couldn't make it to profitability with the metrics that they had.”

So Covad slowed its national and international expansion to 2000 central offices (COs) in the U.S., laid off 800 people (26% of the work force) and took steps to shave costs by 20% to 30% in 2001. Covad also took a hard line with accounts receivable and put strict credit-worthiness checks into place for new lines.

“These steps taken by Covad's new senior management team are clearly the right ones, in our view, and we may hear about further cost-cutting initiatives beyond this initial round,” wrote James Henry, executive vice president of broadband research at Bear Stearns & Co. “We believe that The Street will ultimately respond positively if the company is successful in purging its accounts receivable problem and in establishing a clear path to profitability.” Nonetheless, Bear Stearns suspended its rating on Covad until the company's situation clarifies.

NAS' Aust also contends that his data CLEC is different, and that it has always planned to be.

“We have a very resilient business plan,” he says. “We can expand and contract. We're not totally dependent on scale.”

And a good thing, too, because NAS made a sharp course reversal this summer. In June, the company, based in Herndon, Va., announced the completion of Phase 2 of its national network, giving NAS a network of 500 COs in the northeast.

“We have achieved our goal of creating a dominant ATM-based network presence in the mid-Atlantic region, which is essential to serving the business-class sector of the broadband DSL market,” Aust said in June.

All that changed in September. As McMinn observes, profitability became the thing. Determined to make NAS cash-flow positive by 2003, Aust and his colleagues were among the data CLEC executives who halted their national ambitions, laid people off and began paying attention to a much smaller bag of knitting. While Rhythms headed into the storm and Covad trimmed its sails, NAS headed for deeper, calmer water.

“We are focusing more and more on those businesses which really value services that we provide—higher speeds, mission-critical solutions, bundled services,” Aust says.

Sharks circling

None of this full-speed-ahead, trim-the-sails, head-for-deeper-water stuff for Mark Washburn, the CEO of HarvardNet. Washburn has run up the distress signal and called the Coast Guard, dropping 280 of his crew over the side.

Through the summer, HarvardNet continued to offer “business-class DSL” and bill itself as a “super-regional data CLEC.” The privately held, Medford, Mass.-based company had opened offices from Maine to New Jersey and was getting ready to “take a bite out of the Big Apple.” But by August, HarvardNet was already stressing its hosting capability in its press releases, and it announced its departure from the DSL business on Dec. 6, 2000.

“The DSL business is very capital-intensive, and the recent dramatic downturn in the financial markets makes it difficult to continue offering DSL services,” Washburn said in a prepared statement. “As a result, we are restructuring the company in order to reduce operating expenses while focusing our energy and resources on the most promising side of our business: Web content hosting and managed services.”

None of this surprises Current Analysis' Moore. He talks about ILECs as being winners and about data CLECs as “surviving”—if they're nimble and lucky. “By slimming down and setting more realistic goals, they are giving themselves a fighting chance to survive the shakeout,” he says.

Moore talks about Covad as a possible winner, too. He is impressed by those 250,000 access lines, though he is concerned about the company's ability to weather the current storm with a considerably smaller crew.

And, on Oct. 20, 2000, the first of many class-action shareholder lawsuits was filed in the U.S. District Court against Covad by the firm Milberg Weiss Bershad Hynes & Lerach. Unusually, the complaint was signed by William Lerach himself, who wrote the book on the subject and who might be described as the great white shark of class-action law.

The complaint charges that Covad and certain of its officers and directors misrepresented the revenues Covad would get from its purchase earlier this year of BlueStar Communications, a privately held DSL carrier specializing in smaller markets. Class-action lawsuits rarely go to court, but settling them can be expensive.

It's just one more wave breaking over the wheelhouse.

Ken Branson is a freelance writer based in Hackettstowne, N.J. His e-mail address is luddite@goes.com.