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STREET WISE By Amey Stone May 6, 1999


ISP Stocks: Worth Dialing for a While
AT&T's broadband deals could hurt eventually. But for the near term, most Americans who flood online will first do so via standard modems

During the intense bidding war for cable operator MediaOne Group (UMG), Internet service providers (ISPs) suffered what may best be described as collateral damage. As the scramble escalated to see who would capture the audience for Web-based video, voice, and data, investors couldn't help but wonder how dial-up ISPs would fit into a future that could well be dominated by cable. America Online (AOL), which could have gained a foothold in cable if Comcast's (CMCSA) bid for MediaOne had been successful, was left out in the cold as AT&T (T) apparently won the day. And if AOL lost out, what was an analyst to think about the future of leading ISPs such as Mindspring Enterprises (MSPG) and EarthLink Network (ELNK)?

ISP stocks, already well off their highs, fell as much as 10% the morning of May 5 as the deal was announced. Then, investors' concerns abated as quickly as they had surfaced. Many ISP stocks regained lost ground throughout the day and closed up. Mindspring ended at 94 3/8 for a gain of 6 3/8, EarthLink closed at 65 5/8, up 1 5/8, OneMain.com (ONEM) closed at 29 7/8, up 1 7/8, and AOL closed at 130, up 3 1/8.

FOCUS ON THE OBVIOUS. The message from Wall Street is that while the long-term prospects of ISPs may be cloudy, near-term trends are so positive that the stocks are well worth owning until the picture clears. Analysts say the broadband future -- whether it arrives via cable or telephone lines -- is too far off and too speculative to worry about now. They suggest that investors focus on the obvious -- which is that the vast majority of the millions of Americans who will flood online over the next few years will first do so via dial-up modems. At current rates, those customers will ante up a hefty $20 a month, and possibly more, as ISPs add premium services.

 

"ISPs will emerge as very nimble, rapidly growing companies," says Ladenburg's Squali
 

Analysts believe that by the time broadband arrives, ISP companies will have such a hold on millions of customers that cable or telephone companies will either cut a broadband deal or snap them up. While perhaps not the segment of the Internet industry with the broadest potential, the ISP business is suddenly looking a little safer than some high-flying Net stocks. "By identifying the ISPs that are the leaders in building the Internet infrastructure as it grows rapidly, even risk-averse investors can participate in the Internet stock boom," wrote Kristen Koh, an analyst with Credit Suisse First Boston in a Dec. 15, 1998, report on the industry.

"I think we're going through a kind of tough time for these stocks," says Youssef H. Squali, an analyst with Ladenburg Thalmann & Co. "There is so much information coming at investors involving phone, cable, and Internet companies, it is hard to analyze it all to see what the end result is going to be." But he thinks this phase will pass. "ISPs will emerge as very nimble, rapidly growing companies."

DSL DEALS. In fact, the threat of competition from cable companies has long loomed over ISP stocks. While it makes sense that one day every Internet connection will be high-speed and delivered to homes bundled with cable and phone service, that day could be a long time coming. Jupiter Communications estimates that by 2002, only 12% of Internet access will be via cable, 6% will be via DSL (digital subscriber line), the phone companies' broadband play, 1% will be by satellite, and 78% will be by dial-up. Many analysts believe cable and dial-up will coexist. ISPs are already starting to offer high-speed DSL by inking deals with the regional telephone companies, which provide the high-speed DSL technology. "Mindspring could do very well even if DSL takes only 20% of customers," says Drew Cupps, manager of the Strong Enterprise Fund.

While cable companies are resisting now, analysts also believe they will eventually have to cut a deal with AOL and other ISPs to gain access to their millions of customers. "Ultimately I think those deals will happen," says Jeff Sadler, an analyst with FAC/Equities, a division of First Albany. "It's just a matter of pricing and who gets the money." EarthLink and Mindspring also won't get shut out. "When AOL cuts the big deal, these guys can go back in behind and say, we want a deal that looks like that," says Sadler. Mindspring and EarthLink already have deals with small cable companies, points out John Tamburro, an analyst with Jefferies & Co. "I'm not really worried until the picture clears," says Mark Cavallone, an analyst with Standard & Poor's equity research group. "We're still very early in the game."

 

Aside from the cable risk, Internet stocks could drop, blocking ISPs' access to capital
 

ISPs shouldn't even be focusing their energies on broadband now, says Abhi Chaki, who covers broadband and Internet access strategies for Jupiter. Instead these companies need to work on increasing their customer bases as quickly as possible. He expects massive consolidation to reduce the number of independent ISPs from 4,000 to 5,000 currently to 700 by 2002. Then the biggest ISPs can go to the cable companies in three years and say "let's talk business," he says.

Next to AOL's 17 million subscribers, EarthLink's and Mindspring's roughly 1.1 million subscriber bases sound paltry. But they are still in the top five of providers and are growing rapidly. EarthLink's and Mindspring's revenues are expected to grow roughly 100% in 1999, while the industry's average growth rate is 30% to 40%.

Clearly, even without the cable threat, the ISPs face many risks. Downward pressure on access fees would hurt these companies. Moreover, while customer churn rates have stabilized at around 6% a month (and are lower for leading companies such as EarthLink and Mindspring), it is still easy for customers to switch providers. Perhaps the biggest risk is that the market for Internet stocks could drop, which would limit the ISPs' access to the capital they need to grow through acquisition, says Squali. "Though the cable risk is clear and real, I don't see it as imminent."

Amey Stone is an associate editor of Business Week Online


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Amey Stone covers the markets and investing for Business Week Online




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