Sector Spotlight: For Internet Service Providers the Issue Is Free ISPs

Free worked for television. But can it work for the Net? The Internet service provider industry is still struggling to figure that out.

More than 10 million people have signed up for free Internet access from four well-funded operations over the past year. Though these ventures' ultimate success is still unclear, their potential impact on the industry isn't: With any success, they easily could nibble at subscriber growth and margins at industry stalwarts such as America Online (AOL Quote), which has 18.6 million domestic subscribers, and EarthLink (ELNK Quote), which, with last week's deal to acquire ISP OneMain.com (ONEM Quote), will end up with 4.2 million subscribers.

Whether the free ISPs can succeed appears to be a question best-answered by watching NetZero (NZRO Quote), the only publicly traded ISP that thinks it can make a business purely out of connecting Americans to the Internet for free. With its stock down 80% from its December high, the company is encountering the same skepticism confronting other cash-burning Internet companies. But if it can pull off its business plan, it could lead free Net access out of its niche.

Giving It Away

NetZero, which has lost $64 million since mid-1999 in its attempt to build the free-ISP business, has distinguished company. Since last fall, at least three other free Internet access services have launched in the U.S.: Kmart's (KM Quote) BlueLight.com, AltaVista Free Access, operated out of CMGI (CMGI Quote) subsidiary AltaVista, and an offering from Juno Online Services (JWEB Quote), which markets a combination of free and paid Internet connections. Combined, these three services have signed up more than 6 million freeriders.

ISP Stocks Take Their Knocks

The free ISP concept, as explained by its supporters, is pretty simple. Instead of charging people money to use the Net, you make them watch advertisements -- ads that can be clearly targeted at users, because you're collecting information about them as a condition of service. "Telecom costs are dropping about 50% per year," says Jeff Goverman, research director at Pacific Crest Securities. "Targeted advertising rates are going to increase over time. At some point in time, the lines cross." Pacific Crest hasn't done underwriting or investment banking for NetZero; Goverman has a strong buy, his firm's highest rating, on the company.

The path to profitability -- the concept that newly skeptical Internet investors are obsessing over these days -- may be sweet. (TheStreet.com explored that issue in a recent series.) But it's not short. And NetZero, with its financials on display, is the best place to see that. Goverman estimates that in the quarter ending September 2000, NetZero's revenue will cover its telecom costs -- the costs of actually connecting people to the Internet -- for the first time.

Costs Aplenty

Of course, telecom costs aren't the only costs. You've got marketing expense, because if you're in a hurry, you have to advertise your product, even if you're giving it away. You've got to hire a staff of salespeople to go out and sell advertising and e-commerce deals for the ads. You need another set of people to run the computers. Goverman thinks it will be 2002 at the earliest before NetZero can generate positive cash flow from operations.

NetZero might even have the cash on hand to get it that far. In late April, Qualcomm (QCOM Quote), which had already launched its own foray into ad-supported Internet through a new version of its Eudora email program, announced it was buying a 10% stake in NetZero for $144 million. Add that money to NetZero's unrestricted cash and securities on hand at the end of March, and you get a company with $270 million in the bank. That, says Goverman, should be enough to finance NetZero's operations until it starts generating cash from operations.

But the path could be bumpy, not just because Juno earlier this month filed suit against NetZero and Qualcomm for patent infringement related to the ad-supported Eudora. One naysayer is EarthLink President Mike McQuary, who thinks the only way an ISP can make money is the old-fashioned way: charging for access. "Advertising revenues aren't growing fast enough. Telecom costs are coming down fast enough," he says.

Suspect Model?

As recently as three months ago, says McQuary, EarthLink investigated the free ISP concept on its own behalf, but the numbers didn't add up. And he reaches the same conclusion looking elsewhere. "AOL is the best company in the world in getting nonaccess revenue," he says, pegging it at between $6 and $7 per subscriber each month. Meanwhile, AOL's telecom costs are more than $5 per subscriber per month, McQuary says. Add in all the other costs of running an ISP, and the model doesn't work, he says.

How Much Is That ISP in the Window? Price/sales ratios for Internet service providers
Company	Market Capitalization (millions)	Price/Sales
America Online (AOL Quote)	$125,208	19.9
EarthLink (ELNK Quote)	2,068	2.7
NetZero (NZRO Quote)	813	20.0
Prodigy Communications (PRGYA Quote)	764	3.5
Juno Online Services (JWEB Quote)	435	6.6
OneMain.com (ONEM Quote)	287	2.3
Sources: Market Guide, company filings.

(In the United Kingdom, where consumers pay per-minute fees to the phone company for ISP connections, "free" Internet services such as Freeserve (FREE Quote) and AOL's Netscape Online can get a cut of these per-minute charges. But in the U.S., where users pay flat fees for local dialup connections, ISPs don't have that revenue stream.)

Perhaps advertising could support the business in the world of broadband, McQuary says, if a company could use that higher data capacity to transmit more compelling advertising. But with broadband, an ISP's telecom costs double, he says. "It's an awkward place," he says. Instead of going free, McQuary sees more promise for EarthLink and the industry in expanding internationally.

And yet the free ISP concept is gaining supporters. Youssef Squali, Internet analyst for ING Barings, recently upgraded NetZero from hold to buy on the strength of its revenue for the quarter ended March 31. Revenue of $16.9 million represented a sequential increase of 38%, which Squali labels "very impressive." The analyst's firm hasn't done underwriting for the company.

Goverman is also heartened by the deal NetZero announced with General Motors (GM Quote) in January, which could translate into as much as $68 million in revenue for NetZero over four years. "The GM announcement was obviously a watershed announcement," Goverman says. "That's real money for most people. Even GM."