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STREET WISE by Sam Jaffe November 29, 1999

Covad: Giant Steps for "the Next Baby Bell"
The upstart DSL provider got a boost from an FCC ruling that could propel it to the big time

Unlike a lot of telecommunications startups, Covad Communications (COVD) didn't wait for precisely the right regulatory environment to begin operations. Instead, it began building a nationwide broadband network before it had an unambiguous green light from the Federal Communications Commission.

A risky move -- but it proved to be wise once the FCC ruled on Nov. 18 that regional Bell operating companies have to let digital subscriber line (DSL) providers, such as Covad, deliver their services using the Bells' dual voice/data lines instead of limiting these companies to lines that carry only either voice or data. Covad's stock didn't move on the day of the announcement, but it had jumped 50% in the previous two months in anticipation of the FCC's decision. And it still has plenty of room to run, if all of Covad's plans fall into place.

Covad is known in the telecom world as a CLEC, for competitive local exchange carrier, which sells data and local and long-distance voice services mainly to businesses. Covad's specialty is selling DSL service -- a form of Internet connection that's nearly as fast as cable modem or satellite -- to small and midsize companies. It's a high-growth business: Forrester Research estimates that DSL usage will multiply nearly twenty-fold in the next five years.

GETTING LEVEL. The problem with providing DSL service is that you have to reach your customer via local phone lines, which you have to lease from their owners -- the Baby Bells. In one of the delicious quirks of telecom regulation, the Bells also sell DSL service. And until the FCC issued its decision, they were able to give themselves a lead by forcing upstarts such as Covad to offer only "single-line" DSL service. The FCC decision enabling CLECs to offer dual-line service will put all competitiors on a level plane.

The ruling will take some time to boost Covad's revenues: The FCC has given the Bells 180 days to implement the new rules, and they could delay things by appealing. But that could make regulators angry, which might not be wise while the Bells are asking those same regulators to let them sell long distance in competition with AT&T (T) and MCI WorldCom/Sprint (WCOM).

By the end of next year, Covad and other CLECs most likely will be able to provide combined voice and data lines to business and residential customers. The timing couldn't be more perfect for Covad, because that's also when the initial stage of a network it's building will be completed: The company is spending more than $1 billion over the next 12 months to install DSL equipment at more than 2,000 telephone central offices. That will give Covad the ability to sell DSL to anyone within a square mile of the central office. Once data gets from the DSL customer to the central office, it will flow over the Baby Bell's pipeline, for which Covad pays a fee. "By the end of next year, Covad will have a network that reaches 50% of all homes and businesses in the U.S.," says James Henry, an analyst who covers Covad for Bear Stearns. He rates the stock a strong buy and has a 12-month price target of $90. The stock closed on Nov. 26 at $58.

LOWER COSTS. Only one company can match that kind of penetration for high-bandwidth access: AT&T. But AT&T will do it with a huge cable-TV network that's being retrofitted for Internet and voice service. The cost of upgrading that network is enormous. It's estimated that for each potential customer, AT&T will have to spend $250 on infrastructure before it can even offer the service -- which the customer may well decide not to use.

Covad, by contrast, faces much smaller infrastructure costs -- about $5 per customer. True, it will have to provide every customer it signs up a modem that costs $200 to $250. But it doesn't have to lay out that money until the customer has already signed up -- and it can amortize that cost over the life of a long-term contract, usually a minimum of three years. "One of the advantages of DSL over cable access is that the initial capital expenditure is much smaller, which makes it a cheaper alternative for the construction of the network," says Goldman Sachs analyst Ken Hoexter, who rates Covad a strong buy.

Once the network is in place, moreover, Covad won't have to worry about converting itself from a line-laying company to a marketing and sales company. That's because it's in the wholesale business. Rather than sell DSL access directly to businesses or households, it sells it to large Internet service providers and phone companies, including Concentric Networks (CNCX), AT&T, and Qwest Communications (QWST). Covad doesn't "have to do the heavy lifting of selling the service," says Goldman's Hoexter. "That lets them concentrate on keeping the network running efficiently."

DUAL EDGE. Covad's main competitors in the future will continue to be the Baby Bells. But it should have two advantages over them. One will be the national footprint it expects to have by yearend 2000. Second will be a simple fact of life: "The Baby Bells don't have a good track record when they aren't operating an oligarchy," says Bear Stearns' Henry. "Look at SBC's (SBC) Internet service provider business, which has been operating for years and still only has 650,000 customers. That's not exactly threatening America Online (AOL) or any of the other independent ISPs."

Thanks to Covad's powerful marketing partners -- such as AT&T and Concentric -- it should attract lots of customers once its network is in place. The downside: Covad will have to share revenues with its partners. Right now, the Bells charge Covad an average of $22 a line per month for access to their network. That figure should drop to $10 after the FCC ruling takes effect, says Henry. But Covad will still have to split the rest of the $50 a month that customers pay for the DSL line with a marketing partner, which will leave it with operating profit margins of about 30%, according to Henry. That's lower than current Baby Bell margins, but it isn't too shabby for a company that didn't even exist a few years ago and that went public last January.

Covad could boost its margins by deciding to sell voice service to individual consumers. "This company can have a pleasant future as a wholesale provider of DSL lines, or it can try to offer a complete telecommunications package to consumers and become one of the major telecom players," says Banc of America Securities analyst Mike Renegar, who rates the stock a hold. He's waiting to see if Covad develops a voice business before he upgrades that rating. "If they can successfully leverage the voice side of the business, this stock has an enormous upside," Renegar says.

Money managers are starting to agree. Monument Internet Fund (MFITX) manager Alexander Cheung has been buying Covad as a play on broadband Internet access. "We looked at the Baby Bells," Cheung says. "But then we realized that we'd rather own a company that will be the next Baby Bell. That's what we expect from Covad."

Jaffe writes about the markets for Business Week Online

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