Rerouting Telecom Law
Few people appreciate the highs and the lows of a competitive telecommunications industry better than Chuck McMinn.
For five years, the co-founder and chairman of Covad Communications Group Inc. was hard-pressed to stop Wall Street from throwing money at him to build what grew into the only nationwide high-speed digital-subscriber-line, or DSL, network.
After spending $1.3 billion, Covad found itself insolvent in 2001 as its technology-oriented business customers failed by the handfuls. But it was out of Bankruptcy Court in four months, and has since become a nimble navigator in the fast-changing telecom world.
Local phone competition ushered in by the Telecommunications Act of 1996 has taken many twists as regulators have tried to come up with adequate rules. Covad has felt each bump along the way.
Covad, which hasn’t earned a profit from operations since its founding in 1996 , is arguably more responsible than any other firm for bringing down the price of high-speed Internet access.
That was McMinn’s goal from the start.
“We saw an opportunity to take the price down from several thousand dollars a month to the simple tens of dollars a month,” he said. Baby Bells such as SBC Communications Inc. weren’t going to do that because “they owned the customer,” he said. Until San Jose-based Covad and its ilk came along, “they were the only game in town for all this connectivity.”
Written off at times by analysts and investors, Covad is one of the new competitors to have clawed its way through the industry’s morass and turned its fortunes around. It is becoming a full-fledged provider of voice and data services through its recent purchase of GoBeam Inc., which uses a technology known as voice over Internet protocol, or VOIP, that transmits voice over the Internet like e-mail.
“They’ve regained their footing quite well, and they’re very well-focused on what they’re doing,” said Charlie Carr of tech research firm Gartner Inc.
As the largest independent DSL provider, behind only the four Baby Bells, Covad mainly sells wholesale services to resellers such as AT&T; Corp. and WorldCom Inc.’s MCI unit. It even counts the Bells among its customers, reaching a deal last week to share lines in Qwest Communications International Inc.’s 14-state Western territory.
“We’re kind of like Switzerland,” said Chief Executive Charles Hoffman. “We work with them all.”
A onetime engineering executive at Intel Corp., McMinn learned to strive for ever-faster microprocessors and to push down prices to build demand. Watching the phone companies, he saw an opportunity to do the same thing with Internet access.
The Bells had long had DSL technology, he maintains, but they effectively kept it under wraps by pricing it as if it were as precious as the expensive dedicated lines that big corporations use to move electronic data quickly. And, analysts have said, the Bells didn’t even want to market DSL for fear it would cannibalize their highly profitable business in those T-1 lines.
Spokesmen for Bell companies say their companies didn’t have the technology ready for the mass market until 1998.
DSL is much cheaper to deploy than T-1 lines, mainly because it can use the existing copper wires that connect nearly every home and small business to the nation’s phone network.
Covad began selling DSL in San Francisco in late 1997 through start-up Internet service providers, or ISPs, that sprang up in high-tech’s boom days. It was the first commercial launch of high-speed service.
“We thought that this business was going to evolve the way the cable-TV or the paging or the cellular businesses did,” McMinn said. “There would be this whole flurry of companies, each building a network in an individual city, followed by some sort of roll-up into a national provider.”
Instead, Covad got what he called a “very serendipitous opportunity.” Wall Street investment bankers told Covad executives they didn’t have to wait until the San Francisco effort panned out. They could get funding right away and start putting splitters and equipment in other major markets and sell through thousands of ISPs nationwide.
With only 50 subscribers, Covad raised $135 million in 1998 to go into the top six metropolitan areas. The next year, it raised nearly $1 billion more through an initial stock offering and two bond offerings, building out into the 53 biggest markets by the end of 1999. It continued expanding in 2000, almost exclusively as a wholesale provider to ISPs such as Southern California’s Flashcom, Internet Express and Accelerant, all now defunct. EarthLink Inc. became its biggest customer.
But with losses mounting in the tech industry and stock prices out of whack, Wall Street soon turned off the spigot. Companies failed by the hundreds. In one three-month period in 2001, nearly a third of Covad’s ISP customers went bankrupt. Covad tried with limited success to continue providing service directly to the homes and businesses served by those failed ISPs.
Hoffman joined the company in 2001 to help turn around operations. “Revenue was dramatically impacted, and the board started looking a little closer and found out, ‘Oh gosh, there’s $1.4 billion in bond debt without a good way to pay that off,’ ” he recalled.Creditors and company executives hammered out a reorganization plan that Covad took to Bankruptcy Court. The company filed its petition and plan in August 2001, and was out of court in December. Bondholders ended up with 19 cents on the dollar and 15% of Covad’s stock.
Then competitive and regulatory pressures began weighing in. As the Bells gained authority under the Telecom Act to offer long-distance service, they began selling bundles of services, such as local, long distance and DSL, leaving Covad with little room to pick up the bigger profit margins in direct DSL sales to consumers and businesses.
Last year, Covad lost $100 million, or 44 cents a share, on revenue of $389 million.
During the retrenchment, McMinn and Hoffman had fired 65% of the workforce, rearranged debts and deals and started building up direct sales to small businesses, rather than wholesaling. Direct sales grew from 4% of revenue to 20%.
The company is back in expansion mode with plans to boost direct sales further by offering voice and data with technology from GoBeam. The purchase of GoBeam for $48 million in stock is expected to be completed in May.
Covad also is putting VOIP-enabled DSL gear into 200 telephone exchanges to bring its total to 2,035 sites nationwide. Its network will be able to reach 50 million homes in 35 states, including the top 100 markets
“The good news for us is you need broadband for VOIP, and we’re a natural ally for that,” Hoffman said.
Covad has converted its DSL switches to handle voice as well, and analysts see that as a smart move. “As VOIP becomes more important, Covad’s situation improves,” said analyst Blair Levin at Legg Mason in Washington.
Only a year ago, the company was in a funk with VOIP just a “someday” dream. The Federal Communications Commission had ruled that the Bells would no longer be required to share lines with DSL providers, a rule that primarily affected Covad as the only national DSL competitor. “The night before the vote, When we found out we were losing it, it was pretty devastating,” Hoffman said.
But the FCC also required the Bells to provide rivals with access to lines and gear at wholesale prices. Covad quickly found DSL partners in MCI, Sprint and other long-distance carriers that had started offering local service on Bell lines. A month before the FCC vote, Covad had signed a little-noticed accord to supply DSL to AT&T;’s new local customers.
Last month, however, a federal appeals court threw out those competition rules, putting Covad’s DSL strategy in jeopardy. But the decision is leading some companies to reach contracts among themselves, as Covad and Qwest did. Covad also is negotiating with other Bells.
Also last month, Covad agreed to sell the latest DSL gear -- capable of downloading information at 3 megabits a second, or twice as fast as current DSL -- to America Online Inc. users.
For Covad customers such as EarthLink, it’s all about having competition that the 1996 telecom act promised. “I think competition is very, very healthy,” said Steven Dean, EarthLink’s information technology director. “I want local exchange carriers to lower prices. I want to leverage them against each other.”
For Wall Street analysts like Vik Grover at Needham & Co. in New York, Covad’s ability to alter its business plan quickly is going to help the company grow significantly. “Covad,” he said, “is a transition story.”
