Will Free Internet Access Cause Anarchy in the U.K.?

AOL goes on the defensive, and independent ISPs are feeling some pressure.
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British Internet service providers, or ISPs, have thrown the U.S. business model of subscription charges out the window, and they're cutting one another's throats by offering free Internet access. While this may be great news for consumers, Internet investors are likely to find this trend resulting in an increasingly smaller number of players from which to choose.

The ISP

X-Stream

began the trend by offering a free service last March. However, other ISPs didn't follow suit until electronics retailer

Dixons Group

began

Freeserve

in September and, in a matter of months, overtook

AOL

(AOL)

as the leading provider in the U.K.

This month

British Telecommunications

(BTY)

jumped on the bandwagon by announcing its

BTClick+

service was now

ClickFree

. This move effectively killed the pay-as-you-go business model that BT had been using, which simply levied an extra 1 pence to the local telephone call rate when accessing the Internet.

When Free Isn't

The economics of "free" Internet service are driven by the relatively high local call charges in the U.K. Local rates vary depending on the telco, but a typical one-hour connection to the Internet at the weekend rate costs 60 pence, but it costs more on weekdays.

In a formula set by regulators at the

Office of Telecommunications

, or Oftel, around 20% of that fee goes to the local loop carrier British Telecom, while 80% goes to the long-distance carrier (in Freeserve's case,

Energis

). Of that 80%, Freeserve gets a privately negotiated portion. The ISP hopes to receive money from technical support, advertising and e-commerce partnerships, as well as a slice of the connection fee.

The phenomenal success of Freeserve since its inception in September has led Dixons' management to begin talking about a spinoff. The

Financial Times

quoted the head of Freeserve, John Clare, as saying a demerger is an "issue that we will have to think about in due course," but a spokeswoman stresses to

TSC

that any move in this direction is "not imminent."

The service is certainly gaining visibility among investors. Since Freeserve was launched, Dixons' shares have almost doubled in price. According to

Hemington Scott

, a London brokerage, the 1999 consensus for Dixons' earnings is 38 pence per share, meaning at Monday's closing price of 1,054.5 pence, the shares are trading at 27.8 times prospective earnings.

Dixons has brought forward the break-even date for Freeserve to April from the end of 1999. Shobhit Kakkar, a business analyst at the London-based consultancy

Fletcher Research

, estimates Freeserve's total revenue -- including the portion that must be paid to the carrier Energis -- at about $11.6 million per month. This is far higher than other ISPs in the U.K. and is set to grow further with revenue streams from advertising and e-commerce.

There are doubters over the wisdom of a Freeserve spinoff. Nick Brown, an analyst at

Jupiter Communications

, a new-media research firm in London, argues it would be counterproductive. "Freeserve offers a potential channel to 'sticky' customers," he says. "The value of Freeserve comes from owning it. You want first dibs on the potential customers that go online."

However, Kakkar believes Freeserve is more independent of its master than other branded ISPs such as

TescoNet

, and the benefits of a demerger could outweigh these synergies.

Tesco

, a British supermarket chain, was one of the first providers to follow Dixons' lead when it began offering free Internet access to its approximately 14 million Clubcard members. Kakkar explained that the raison d'etre behind TescoNet was to encourage existing Tesco customers to log on to the Net by offering free perks at its virtual stores, just like it offers free parking at its real stores. In this way, the service may be tied too closely to the brand's existing business to allow a spinoff anytime soon.

A Shakeout Looms

This move toward free access has obviously put the squeeze on the independent ISPs. They already occupied a precarious position in the Internet supply chain -- between the owners of transmission networks and the owners of content available on the Internet -- and free access has only exacerbated this shaky position.

As a result, shares of independent ISPs

EasyNet Group

and

Internet Technologies Group

-- which benefited handsomely from the run-up in U.S. Internet stocks -- have fallen steadily from their peaks at the beginning of this year. EasyNet is down from its peak of 280 pence in January to close Monday at 230.5 pence and ITG is down from 172 pence to today's 140 pence.

Fighting back, ITG last month announced it has been granted a license by the government to operate its own international network based on circuits acquired on long-term leases. ITG believes that in the short term, the license will improve its margins on corporate services by enabling it to buy circuits from BT at wholesale prices. In the longer term, it will allow ITG to interconnect with carriers such as BT and share the call revenue generated by its customers.

Fletcher's Jones says there is talk that ITG will offer free access to its residential clients and focus more on its pay services to businesses, offering a whole gamut of corporate services.

Despite these moves, the future isn't bright for these ISPs. "Dial-up access providers that fail to achieve subscriber numbers of at least 300,000 are unlikely to remain competitive in the long term," says Katrina Bond, an analyst for the U.K.-based telecom consultancy

Analysys

. As of the beginning of this month, ITG's dial-up subscriber base had reached 105,000.

It's also speculated that more telcos may decide to acquire independent ISPs. Last year,

ScottishTelecom

bought

Demon Internet

, then the U.K.'s largest Internet service provider, for $110 million.

Online service provider AOL doesn't appear quite ready to throw in the towel either. AOL spent a painstaking three years building up a client base of about 500,000 only to watch its lead in the U.K. market evaporate in four months when Freeserve launched its free service.

Unlikely Allies

In response, AOL launched a major TV advertising campaign over Christmas to promote its content, and last week, it announced it has teamed up with Rupert Murdoch's

British Sky Broadcasting

(BSY)

satellite service.

BSkyB is looking to ward off the potential threat from cable companies, which unlike satellite operators can offer interactive digital services, by offering its digital subscribers free Internet access. Its marketing alliance with AOL initially means BSkyB will provide content such as the

Sky Sports

Web site to AOL, and in return, AOL will market Sky's digital service to its subscribers.

Although AOL maintains it hasn't been affected by the move to free access, Fletcher's Kakkar argues, "The line between ISPs and OSPs

online service providers has been graying for some time now. Freeserve's site is becoming an impressive Web portal in its own right."

Those hoping for a similar Internet investor craze in Europe as the one in the U.S. will no doubt be disappointed by all this. The Internet may have been born in the U.S., but considering the medium's revolutionary nature, it's hardly surprising that its European offspring would grow up in a different way.

As originally reported, this story contained an error. Please see

Corrections and Clarifications.

Concerned about the future of Net stocks? TSC is holding a special summit on Friday to discuss the Internet sector. Join columnists James J. Cramer and Herb Greenberg, Andy Kessler of Velocity Capital, Nicholas Moore of Jurika & Voyles, CIBC Oppenheimer's Henry Blodget, Internet Fund manager Ryan Jacob and Brian Salerno of Munder Capital. You'll be able to listen to a live broadcast of the event and later read the transcripts -- but first, help us shape the discussion. Visit

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