Posted 10/2000

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DLEC Buyups: Rescue or Ravishment?
NORTHPOINT, VERIZON DEAL COULD BE SIGN OF CONSOLIDATION TO COME IN DSL MARKET
By Gail Lawyer

Though it might be difficult to find an executive at a DSL wholesaler to admit it, there's little doubt that companies such as Covad Communications Co. (www.covad.com), NorthPoint Communications Group Inc. (www.northpoint.net) and Rhythms NetConnections Inc. (www.rhythms.com) didn't envision operating as a standalone entity for very long.

In the early days of DSL wholesale, pundits predicted that there would be a proverbial window of opportunity--maybe two to five years--for these data LECs (DLECs) to build out to as many COs as possible and deploy lines to end users.

With dreams of dollar signs dancing above their heads, executives, investors and employees with stock options in DLECs hoped to quickly build up their companies' values and sell to the highest bidder when the time was right.

But now that the first big DSL acquisition has taken place--Verizon Communications (www.verizon.com), the combination of Bell Atlantic and GTE, scooping up a majority stake in NorthPoint for a mere $800 million--the DLEC community may find its fingers painfully pinched as the window of opportunity slams shut.

A deep-pocketed knight in shining armor was exactly what the executives of the big three DSL providers were looking for when they founded their companies, says Mike Smith, co-founder and managing director of the Telecom Strategy Practice at Stratecast Partners (www.stratecast.com).

"When looking at the U.S. telecom market, for a BOC or IXC to compete nationally, they needed broadband facilities," Smith notes. "But the problem the DLECs ran into was that they took their eyes off the service provisioning ball."

Wall Street has valued these DLECs on their ability to deploy DSL lines. But for the most part, the DLECs haven't lived up to their provisioning promises, and they've been punished by lowered stock valuations.

"The window of opportunity that is closing on them is the opportunity to maximize the value of the stock they possess," says Smith.

NorthPoint's stock, like the stocks of Covad and Rhythms, has been trading at or near its 52-week low. On Aug. 8, when the Verizon deal was announced, NorthPoint's stock closed at $14.25 per share. But in the week following the announcement, the stock fell into the $12 range, just $2 above its 52-week low.

On the same day the NorthPoint-Verizon deal took place, Covad's stock closed at $16.56, just slightly above its 52-week low of $15.25. Rhythms stock price was $14 on Aug. 8, but dropped into the $10 range the following week. Rhythms' 52-week low is $10.19 per share.

Verizon purchased its stake in NorthPoint for veritable fire sale prices, say industry analysts. For $800 million, Verizon got a national broadband services play that can potentially reach 63 million subscribers. That's a significantly smaller investment than the $44 billion that AT&T Corp. (www.att.com) paid for broadband access via MediaOne Group's cable systems reaching a similar number of subscribers.

Some analysts believe that Verizon may have robbed the cradle, scooping up NorthPoint just before it was able to prove itself in the market and possibly raise its stock price. NorthPoint has a new back-office system; was readying a national rollout of BLAST, its platform for delivering video and other high-bandwidth content; and had end-to-end transport agreements with Genuity (www.genuity.com) and Global Crossing Ltd. (www.globalcrossing.com).

"All the ducks were in a row and then Verizon swoops in and grabs them," says Carl Garland, principal network services analyst at Current Analysis Inc. (www.currentanalysis.com). NorthPoint "invested a lot of money and energy developing infrastructure. But now they have to get customers, but there wasn't much left in the kitty for marketing."

Financial issues are definitely among NorthPoint concerns that have likely been relieved by Verizon's investment. NorthPoint's business plan was reportedly funded through early 2001, and the company was seeking ways to raise more money.

Of Verizon's $800 million, $450 million will be used to fund NorthPoint's network expansion and ongoing enhancements to its service delivery and support systems, and product offerings. The remaining $350 million in cash will go to NorthPoint shareholders, paying them $2.50 for each share they hold.

This combination of DSL businesses presents a couple of winning scenarios for Verizon, as well.

Beyond the seemingly low price it paid for its 55 percent stake in the new company, which will retain the NorthPoint name, Verizon now will have another organization that will be responsible for dealing with provisioning details. Verizon--more specifically Bell Atlantic--has had well-publicized problems getting DSL lines deployed. The merger "lets Verizon offload all the deployment problems to NorthPoint," Smith suggests.

Most significantly, when the deal is closed, Verizon will have moved all of its DSL services into a new unregulated company that may not be subject to the strict resale requirements affecting incumbent telcos. This could obviously create some concerns from regulators, who are seeking to breed competition for high-speed Internet access.

The Provisioning Problem

"I can't think of any DSL provider that hasn't had [deployment] issues," Lawrence T. Babbio, Verizon's vice chairman and president, said during the press conference announcing the NorthPoint-Verizon alliance. "The service issues are behind us," he added, noting that Verizon installs about 3,000 new DSLs each day.

But despite these apparent improvements, a recently released study suggests that customers are less than satisfied with the provisioning process.

In research released in late July, analysts at ATLANTIC-ACM Inc. (www.atlantic-acm.com) said that ISPs reported mediocre DSL service from wholesalers. The published report, entitled "xDSL Market Sizing: Provider Report Card 2000-2006," shows that average scores for all wholesale DSL providers fall below average in areas of responsiveness of customer service and e-bonding.

"The whole industry is working on a way to deploy without a hassle on the consumer's part," says Liz Fetter, NorthPoint's current president and CEO, who will serve as CEO of the new NorthPoint once the merger is complete. She added that NorthPoint has spent a significant amount of money on its back-office systems in order to streamline the process for ISP partners and consumers (see "Getting What You Wish For").

Coincidence?

In what seemed to be a perfectly orchestrated coincidence, Cahners In-Stat Group (www.instat.com) debuted its report "DSL Service Providers and Their Rollouts," which indicated that BOCs will ultimately prevail in the race to capture DSL subscribers, at almost the exact time that Verizon was announcing its intentions with NorthPoint.>

"The Baby Bells are not home free by any means. Competitive carriers have already won a significant share of the small-business market that should help keep them in the game for some time to come," Mike Lowe, senior analyst for In-Stat's Advanced Carriers service group, said in a statement. But "at the end of the day, CLECs do not own the network, nor do they own the customers. As wholesalers, they are somewhat beholden to their retail partners, and as users of the BOCs' networks, they are potentially at the mercy of the incumbent carrier."

And, in fact, BOCs and IXCs have stakes in DSL providers. SBC Communications Inc. (www.sbc.com), for instance, owns a 12 percent interest in Network Access Solutions (www.nas-corp.com). And Qwest Communications International Inc. (www.qwest.com), which now owns US WEST, has a stake in Jato Communications Corp. (www.jato.net).

Of all the BOCs, SBC might feel the most pressure as a result of the NorthPoint-Verizon combination.

"The deal will motivate SBC to move more quickly out of region," says Smith. SBC has already committed $6 billion to roll out DSL in its service territory and is introducing a variety of competitive local telecom services in 30 cities out of region as a result of its merger with Ameritech.

Smith suggests that SBC may be shopping around to buy its way into national DSL coverage. "Rhythms and Covad are likely to be acquired," he says. "For SBC to acquire both of them, it wouldn't be a huge capital outlay."

As for the new NorthPoint, smoothing out the provisioning wrinkles and adding new services to basic high-speed transport are high on the priority list going forward.

Fetter says that the company will continue to bundle services, such as video and hosted applications, with the high-speed Internet access.

Voice over DSL (VoDSL) is another possibility, considering both NorthPoint and Verizon are testing the technology now. For several months, NorthPoint has been teaming up with voice CLEC Focal Communications Corp. (www.focal.com) and ISP MegaPath Networks Inc. (www.megapath.net) to deliver VoDSL in the San Francisco Bay area.

Verizon's VoDSL trials are still in their infancy. The technology trials with 300 of the company's employees in the Dallas area--part of the former GTE's footprint--began in July. Once the technology bugs are worked out, a Verizon spokesman said that there are about 150,000 small businesses--with two to 12 lines--that Verizon would eventually target in a limited market trial.