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TheStreet Open House

Freeserve Looking for Boost From Free-Call Plan

The progress of Freeserve's (FREE) free-call Internet package is going to be key to its first-quarter results due out tomorrow.

Shareholders will be looking for usage gains due to the new connection package, and are hoping this will counter negative sentiment that has caused the Internet service provider's shares to sag. By allowing users to pay a 10 (about $15) monthly fee to connect to the Internet without paying phone charges, Freeserve wants to boost connectivity revenue, and more importantly to build e-commerce and advertising income from its own content.

But Freeserve faces a crowded playing field in offering a free-call plan: AOL's (AOL) U.K. operation announced a free-call strategy last week, and cable company NTL (NTLI) is doing the same.

Growth among Internet service providers, or ISPs, in the U.K. has been hampered by the fact that users must pay per-minute phone call fees when they log on. This has resulted in staggering phone bills for frequent Internet use. In response, ISPs have launched plans where, in exchange for a monthly fee, users don't pay phone charges when connected to the Net. But this strategy hasn't worked out exactly as planned because of difficulties the ISPs have encountered in working out bulk-rate call plans with British Telecom (BTY). Providers such as AltaVista Europe, a subsidiary of CMGI's (CMGI) AltaVista, and Lineone have been forced to cancel their packages because they couldn't bear the short-term costs involved to acquire subscribers.

Indeed, even Freeserve experienced some problems with its free-call service, but it has promised to sustain the offer. The company is helped by a deal with communications company Energis (ENGSY), which in turn has a bulk-rate plan with British Telecom.

The collapse of rival packages has played into Freeserve's hands, which means the company has been able to win customers from smaller ISPs that are unable to offer free-call packages. The last available figures show that Freeserve now has 140,000 subscribers on its free-call service, and this number is forecast to rise to 200,000.

Simon Edelsten, an analyst at Dresdner Kleinwort Benson, argues the sector will consolidate as heavy Internet users switch to free-call packages. He believes this process will work to Freeserve's advantage because only large ISPs with considerable financial muscle have the funds to bear the short-term pain involved with the packages. Edelsten says that Freeserve will be able to pick up many of the heavy users from other ISPs for no cost.

"Over the last year, people have expected Freeserve to spend money, or issue shares, in order to consolidate the U.K. ISP market. Clearly, if Freeserve is one of the few companies left offering unmetered access, it won't have to issue shares," he says. Dresdner Kleinwort Benson currently has a price target of 450p for Freeserve, and this is based largely on subscriber growth because other ISPs are failing on free-call access.

Nick Bubb, an analyst at SG Securities, agrees. He says that free-call access, together with other potential offerings such as a TV access service, will "turn the tide" for Freeserve.

Dresdner says connectivity will neither be a profit center nor a loss leader in the year to April 2001, stating that free-call access is likely to be subsidized for the next two years. Currently the subsidy is about 2.50 per month per subscriber.

So if there isn't much money to be made from connectivity, why is free-call access so important for the ISP? Freeserve's gamble is that free-call access will mean that more people will be drawn to its content, where advertising and e-commerce revenue really kicks in.

However, not every analyst is convinced that offering cheap access to the Internet means greater traffic to the ISP's content. After all, Internet surfers don't have to have their ISPs' Web sites as their home page. Some sector watchers are concerned that by providing free-call access Freeserve will simply generate traffic to rival portals. Stephan Slowenski from Robertson Stephens International argues that as everyone battles in the access market, Yahoo! (YHOO), which doesn't offer access, is quietly leading in terms of online visits in the U.K.

"Yahoo!'s not spending 80% of its time thinking about how it can make unmetered access work. Instead it is upgrading on its high-margin e-commerce and advertising business," he says. "While everyone else leads the road to the Internet, Yahoo! will be the destination." Nomura's Internet analyst Daniel Bieler agrees that subscribers can use Freeserve to connect to the Net and then completely avoid its content -- thus the ISP will not necessarily gain any extra advertising or e-commerce revenues.

"Freeserve is positioning itself as a portal, and is effectively in the media business. This is going to be tough," he says. Bieler is one of many skeptics on the chance of free-call access helping to revive the company. He feels the portal's international position will be the key factor. Bieler says that management's failure to expand the portal beyond the U.K. boundaries means that Freeserve has now missed the opportunity to take on the rest of Europe.

If it has missed the boat, it seems inevitable that Freeserve will have to seek a partner if it wants to be part of a larger ISP/portal alliance. "As long as it remains independent, its valuation is going to suffer," says Bieler.

The three major ISPs in Europe, apart from AOL, are Germany's T-Online, Spain's Terra Networks (TRRA) and Wanadoo from France. If any of these companies want to take on the U.K. market, they're more likely to talk to Freeserve than to try to attack the U.K. organically. "It's got a strong position in a very large and important market," says Robertson Stephens' Slowenski. "Others have mandates to expand on a pan-European basis and Freeserve seems to be an obvious acquisition target."

It may be a little premature to write off Freeserve, but market participants are increasingly looking for Freeserve to secure an agreement with a credible partner if there is to be any turnaround in its shares. So even good news on free-call access tomorrow may not be enough to revive the fortunes of Freeserve's stock.

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