Covad May Be Wired for Growth


When Charlie Hoffman took the reins of DSL provider Covad (COVD) in June, 2001, he knew he was in for a rough ride. The former CEO of Toronto-based Rogers Wireless Communications inherited a company with a crushing $1.4 billion in high-interest debt that was fast running out of cash and on the brink of being delisted from the Nasdaq. When Hoffman stepped in, Covad's stock price hovered in the $1.05 range, far off its 52-week peak of $13.75. And on Aug. 15, at Hoffman's insistence, Covad filed for Chapter 11.

The company claimed the move would help it survive, but many industry insiders remained skeptical. Now, it appears Hoffman may have had good reason for his blue-skies view as a number of analysts say Covad has a solid chance of making a comeback. The majority of its creditors have agreed to a restructuring plan that will wipe away all debt and hand them 19 cents on the dollar, as well as a 15% equity stake in the reconstituted company. Moreover, Hoffman claims that he has three term sheets on the table to cover the estimated $200 million in financing Covad needs to reach profitability in 2003.

Not that it's easy to believe this rosy scenario after examining the fates of fellow independent DSL providers. The big three of the business, Covad, Rhythms Net Connections, and NorthPoint Communications, all sold fast DSL connections over traditional copper wires, mainly as a white-label service for ISPs. To do this, they needed to coordinate schedules with linesmen from the Baby Bells and mount their own equipment in Baby Bell switching facilities. This proved far more difficult and expensive than they anticipated, in no small part due to the fact that the Bells were competitors in the DSL game.

CASH CUSHION. Add to that rock-bottom DSL service prices for consumers and businesses, and it's no surprise that the three upstarts couldn't make a profit. NorthPoint halted its service in March, 2001. Rhythms Net, which spent $1 billion building its network, filed for Chapter 11 in August, 2001, and sold its assets to WorldCom (WCOM) for just $40 million in October, 2001.

So what's different about Covad? The company still has about $500 million in cash, according to Hoffman. That's down from about $870 million at the end of last year, but it represents far more than Rhythms Net or NorthPoint held in their dying days. Wiping out the company's debt means Covad will save $1 billion in interest payments over the next 10 years (it spent $143 million on interest payments in 2001 alone). And as a debtor-in-possession, Covad will be able to get out of leases and contracts, including those for overpriced equipment that burden its network, according to Dave Burstein, editor of industry newsletter DSL Prime.

Covad's size should also work in its favor. At last count, it had 330,000 customers. That's more than NorthPoint and Rhythms Net combined and 10% of the total DSL market. Meanwhile, potential competitors such as Sprint and WorldCom have scaled back their DSL efforts. As Covad becomes the last real alternative to the Baby Bells, its appeal increases. "A lot of people would prefer to work with Covad because a Bell has you over a barrel if it's the only option. They'll do whatever it takes to keep Covad alive," says Adam Gugliemo, an analyst at research firm Telechoice.

"CRUCIAL" COMPETITOR. Take the case of EarthLink (ELNK). The third-largest ISP, with 5 million subscribers, it uses both the Bells and Covad to deliver DSL. Though EarthLink doesn't break out figures on individual DSL providers, the company sends "quite a bit of business" to Covad because it provides better, smoother service than the Bells, according to Kurt Rahn, EarthLink's communications director. "Having a Covad or a competitive entity is crucial if the incumbent is not installing well," he says.

While working with the Bells to build out DSL networks proved difficult, most of the heavy lifting is done by now. Covad has its own DSL gear operating in some 1,800 Baby Bell central-switching offices, covering 84 metropolitan service areas, including New York and San Francisco. Covad has also won some legal leverage to make the Bells play nice. In the past two years, it filed antitrust suits against three of the four Bells alleging anticompetitive practices. The suits allege, among other things, that the Bells dragged their feet in allowing independent providers access to central offices and attempted to charge exhorbitant prices for space.

Last year, one of the Bells, SBC Communications, settled, paying $150 million for equity and agreeing to buy $600 million in Covad services. Further, some industry insiders think the Bells will favor co-existence, as they that fear killing Covad could stir up more antitrust scrutiny.

FASTER BREAK-EVEN. Thanks to broad market trends, Covad has also gotten some much needed pricing power. Over the past spring and summer, most ISPs levied a 25% increase in the monthly price of residential DSL service, from about $39.95 to $49.95 and higher. That significantly improved the time-to-break-even per subscriber. Jeffries & Co. analyst Sameer Bhasin predicts that even for incumbents in the DSL business, break-even will decrease from 24 months in 2001 to 10 months in 2005.

For Covad, which still has to pay an average line rental fee of about $12 to the Bells for access to the copper circuits that make up the last mile to customers, break-even time is a bit longer. Even so, it estimates that residential customers take just under 24 months to break even, while business customers take a "significantly shorter time." The company policy is not to offer service in areas where per-subscriber break-even would exceed two years.

True, demand for DSL has dragged in recent quarters. Subscriber growth slowed from 41% in the fourth quarter of 2000 to 14% in 2001's second quarter. But analysts believe the falloff is due to the loss of well over 100,000 customers when NorthPoint and Rhythms failed - not lack of demand. In fact, demand for DSL will rise steadily over the next five years, according to Telechoice, which predicts DSL subscribers should reach 13.9 million in 2004, up from 2.4 million at the end of 2000. That can only be good for Covad, which needs to nearly double its subscriber numbers to achieve profits.

"ON THE CUSP"? Covad still faces major obstacles. It remains mired in litigation with Verizon. Covad relies on Verizon for cooperation and access to copper lines, so the suit could prove a matter of contention. And since the incumbents don't have the added costs of line-rental fees, Jeffries & Co. analyst Bhasin says independent DSL providers might not "have meaningful impact on DSL deployment in the U.S."

Further, Covad's target small-business market might worry about signing up with a provider tainted by Chapter 11. Past DSL downfalls provide no comfort. NorthPoint shut its doors literally overnight and left more than 100,000 subscribers in the lurch without high-speed service. About 70% of NorthPoint customers were small businesses, according to Telechoice.

But even in Chapter 11, Covad has maintained continuous service for its customers. It also showed its mettle in the wake of the September 11 terrorist attacks. More than 20,000 Covad customers lost service in New York when Verizon's central office in lower Manhattan, where Covad houses equipment, was damaged by the World Trade Center collapse. By the end of the day, 11,000 lines were back up. Two days later, only several hundred lines - within yards of Ground Zero -- were still down.

That resiliency should serve Covad in good stead as it tries to emerge from bankruptcy. Hoffman sure is bullish. The CEO claims that by yearend, 39 of the 50 geographical regions the company serves will be profitable. "This is a scale business. We are on the cusp," says Hoffman, who hopes to announce additional financing in mid-October. That financing could signal a turnaround for the struggling DSL provider and a sign of better days to come. By Jane Black in New York


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