Covad: Why Investors Hung Up
Worries over an abrupt strategy shift sparked a sharp sell-off at the DSL provider

Robert E. Knowling Jr., chief executive of telecom startup Covad Communications Group Inc. (COVD), is nothing if not self-confident. When he announced on June 16 that Covad, which sells speedy digital subscriber line (DSL) service to Internet service providers, would spend about $200 million to acquire a small Southeastern DSL retailer called Bluestar Communications Inc., unhappy investors clobbered Covad's stock. Shares dropped 27% in one day, wiping out $1 billion of market value. Even if he had known what the reaction would be, Knowling says, he would do it again--but he wouldn't have slept for a month beforehand. ''I'm going to prove them all wrong,'' he says. ''I'll have the last laugh on this one.''

Perhaps, but investors aren't laughing now. Covad has long been the leader among a small crop of startups that specialize in providing DSL service, which gives customers access to the Internet at speeds as much as 30 times as fast as traditional computer modems. Investors were smitten with Covad's business, which focused solely on leasing lines from local phone companies such as SBC Communications Inc. (SBC) and letting service providers such as Concentric Network Corp. (NKLK) and EarthLink Inc. (ELNK) sell bundled packages of DSL and Net access to customers. With neither a costly physical infrastructure nor the burden of expensive customer support, Covad, in Santa Clara, Calif., was the ultimate pure-play broadband provider.

''TESTY.'' Not anymore. With the Bluestar acquisition, Knowling is making a dramatic change in his strategy. Instead of offering DSL only through resellers, Covad also will sell directly to customers. That will put the company into competition with its resellers--and already has prompted a ''testy phone call'' from EarthLink, according to Mike Lunsford, executive vice-president for broadband service at EarthLink. Still, Knowling says the shift is essential. Covad faced a future in which growing competition would push DSL prices--and profit margins--steadily downward. By selling only at wholesale, it didn't have a direct relationship with customers and couldn't offer them more lucrative services like Web hosting. ''I want to control more of my own destiny,'' Knowling says.

More control should equal more revenues down the line. Before the Blue-star deal, analyst Brent A. Bracelin of Pacific Crest Securities figured Covad's average revenues per subscriber would sag from $75 per month this year to just $36 per month by 2004. Now, he estimates, monthly revenues in 2004 will average nearly $45--an improvement of $137 million on Covad's annual top line. ''Owning the customer is vital to Covad's ability to sell services that generate new revenue streams,'' says Amy Harris, a researcher at International Data Corp.

But owning the customer won't come cheap. Because of additional marketing and support expenses, Covad will post cumulative losses of nearly $3.4 billion between now and 2004, Pacific Crest estimates (chart). That's some $627 million more than it would have under its previous business model. And it will have fewer customers--in part, because resellers may sell Covad's service less aggressively now that it's competing with them. Covad projects it will install about 16% fewer new DSL lines in the next 18 months than previously expected. Instead of adding 450,000 new subscribers in 2001, for instance, it will add 378,000.

The prospect of fewer customers and wider losses is making investors skittish. Anxiety over the strategy shift, coupled with the broader tech sell-off, has savaged Covad's shares: After soaring eightfold from their Jan. 22, 1999, initial public offering, to a split-adjusted 66 5/8, they have plunged 75%, to 16 1/2, about double their IPO price. ''A lot of the blame lies on management's shoulders,'' says Bracelin.

NO DEFECTORS. The feisty Knowling is betting his new strategy will turn that around. If he can successfully make the transition to selling DSL as a wholesaler and a retailer, he could end up with a more valuable enterprise in the future. Indeed, future earnings should be much fatter under the new game plan. Bracelin estimates that after Covad turns profitable in 2006 its net income will be twice as high in future years as those projected under the old strategy--although projections so far out are highly speculative. ''I've changed the business strategy to meet changing market needs,'' Knowling says.

Now he's scrambling to limit the fallout from the shift. Knowling and other top Covad execs spent the weekend after the Bluestar announcement on the phone placating resellers. So far, none has said it will ditch Covad anytime soon. ''We'll be a long-term customer of Covad's,'' says Concentric CEO Henry R. Nothhaft. Despite the tense phone call, EarthLink's Lunsford says ''this won't change our relationship for the foreseeable future.'' That, Lunsford says, is because there's so much demand for DSL that EarthLink, Covad's No. 1 reseller, needs all the suppliers it can find.

Knowling has a knack for staying ahead of the curve in the telecom industry. After escaping childhood poverty in Missouri, he had successful careers at Ameritech Corp. and US West. Then, he spotted the yawning opportunity for upstarts created by the Telecom Act of 1996. Since joining Covad in 1998, he has driven its revenues from just $5 million to an expected $270 million this year. ''Covad's core mission was to exploit its first-mover advantage and add more lines than anyone else,'' says Michael Smith, chief analyst for telecom consultancy Stratecast Partners. It has certainly met that goal: With 135,000 lines installed, Covad has connected more people than its next two pure-DSL rivals combined.

Having established that beachhead, analysts say, it makes sense for Knowling to shift from a growth-at-all-cost model to one pegged to wringing more revenue from each customer.

''Covad can do nothing but help expand and grow the markets,'' says analyst Fritz McCormick of telecom researcher Yankee Group Inc. Still, executing his new hybrid strategy--and winning back investor faith---could be the toughest test yet for the confident Mr. Knowling.

By Andy Reinhardt in San Mateo, Calif.

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Covad: Why Investors Hung Up

TABLE: A Bold Game Plan

CHART: Knowling's New Math

CHART: The New Hybrid Strategy Will Spur Revenue Growth...

CHART: ...But Will Lead to Higher Losses...

CHART: ...Which Worries Investors

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