Broadband Costs Pinching EarthLink

Sure, EarthLink (ELNK) and other companies hope to collect high tolls from people signing up for high-speed connections to the Internet. But building that broadband superhighway is taking a toll on EarthLink.

Unfortunately, for the Internet service provider, that's the conclusion investors are drawing from the company's postmarket Monday release of financials for the first quarter ended March 31. And that could be a bad omen for other Internet service providers, including

AOL Time Warner's

(AOL)

America Online.

Like cable companies reporting unabated demand for high-speed Internet access, EarthLink met its goals for adding new broadband subscribers via DSL phone service, cable and other wide pipes.

But Wall Street has quickly turned unhappy with the growing costs for EarthLink of adding new broadband subscribers, and the diminishing revenue the company appears to be reaping per broadband sub.

On Tuesday morning, EarthLink's shares fell more than 22% following downgrades from CIBC World Markets, Jefferies & Co. and Salomon Smith Barney. By midday, the stock had recovered somewhat, trading at $8.02, down $1.51, or 16%. AOL, trading near a postmerger low amid worries of its own on the broadband growth front, dropped 50 cents to $19.37.

Cost and Revs

Though EarthLink added 62,000 high-speed subscribers in the first quarter, ahead of its forecast of 54,000 to 59,000 net new subscribers, investors focused on the cost of broadband growth. High-speed access amounted to only 16% of the company's revenue for the quarter -- compared with 79% for dial-up access -- but high speed is the business that EarthLink and Wall Street regard as key to the company's growth, and its future.

Promotional pricing and the loss of some high-end customers, however, cut the spending of those broadband customers. CIBC World Markets analyst John Corcoran, for example, reports that the monthly average revenue per user declined from $37.90 in the fourth quarter of 2001 to $35.86 in the first quarter of 2002.

Though the company had let Wall Street know it was increasing sales and marketing spending on broadband, analysts weren't happy with how hard that expense hit EarthLink's earnings before interest, taxes, depreciation and amortization, a bottom-line yardstick that EarthLink and other companies emphasize. Earnings before interest, taxes, depreciation and amortization for the first quarter came in at $6.5 million, down from $9.1 million in the fourth quarter of 2001 and at the low end of EarthLink's January guidance of $6 million to $10 million.

With the pricing pressure and marketing costs apparently not going away, EarthLink is nudging down its estimates for full-year 2002. The company says it expects revenue of approximately $1.4 billion for the year, down from January's forecast range of $1.4 billion to $1.5 billion. EBITDA, EarthLink now says, will range from $60 million to $75 million for 2002, less optimistic than the previously forecast range of $60 million to $90 million. The 2002 net loss, excluding merger and acquisition related costs, is expected to be somewhere between 14 cents and 24 cents per share, compared with the prior estimate of a 5- to 25-cent loss.

Growing Disparity

EarthLink's broadband numbers suggest a dichotomy among broadband Internet providers. On the one side are the independent firms that, like EarthLink, rely on telephone companies and cable operators to connect their subscribers to the Net; on the other are network owners, such as cable TV operator

Cox Communications

( COX).

While EarthLink's net new broadband-subscriber additions for the first quarter declined 6% from fourth-quarter levels, Cox's first-quarter addition number rose 13% sequentially. But average revenue per subscriber fell at Cox too, according to Cox's pro forma revenue numbers. It's unclear how Cox's fourth-quarter transition from a partnership with Excite@Home to in-house provision of Internet access affected those numbers.

In any case, the apparent costs to EarthLink, a decent-sized narrowband ISP trying to build a broadband business, indicate similar transition difficulties for AOL. Though AOL can funnel some of its narrowband subscribers to high-speed service through AOL Time Warner's cable systems, the company would appear to face marketing and pricing hurdles similar to EarthLink's as it tries to build its broadband subscriber base via third-party DSL and cable subscribers.

Moreover, the already busy pace of broadband signups among cable operators, says Jefferies cable analyst Kavir Dhar, suggests that cable operators outside the Time Warner Cable stable may be in no hurry to market AOL-brand high-speed access, reasoning they don't need AOL's marketing help just yet. So far, AOL doesn't have any access agreements with rival cable operators.

Additionally, says Dhar, demand for high-speed access among cable TV customers makes it unlikely that cable operators will move quickly to introduce lower-priced tiers of Internet access at lower speeds than current broadband offerings. Given the relatively low penetration of high-speed data among basic cable customers, along with customer enthusiasm for the service, "there's no need for them to do that right now," Dhar says.