Covad leveraging the advantages of DSL technologies

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Founded in 1996, Covad Communications is already the leading independent provider of high-speed data communications services using xDSL technology. It was one of the first to perceive the benefits of DSL and is exploiting its first mover advantage. Robert Knowling the president and CEO talks to Basil Ballhatchet about Covad's plans to have the largest DSL footprint.

Covad Communications was only founded in 1996. However, thanks to its ability to perceive the benefits of DSL, in particular the speed of deployment, the net-centric services provider has rapidly gained market share at minimal cost. Michael Bowen, telecoms equity analyst at BT Alex Brown, comments: ?Covad was really one of the first to go out and grab a lot geographic space if you will in the central offices of the ILECs. So they really were anywhere from 12-15 months ahead of the competition. They have a tremendous number of central offices that are service-ready in the neighbourhood of I believe, 370 central offices as of this last quarter, which places them a little bit ahead.?

Covad Communications has been focusing on the provision of services to small businesses and ISPs. However, they are now looking at the consumer market. Bowen notes: ?They are not competing directly against the RBOCs yet. They have said that they are planning to roll out a consumer-orientated product, albeit using a co-marketing agreement through ISPs. Most of their revenue is coming from businesses, rather than consumers. The RBOCs have to date focused on the consumer segment primarily because they do not want to cannibalize their T1 and DS3 revenues so far. They are not really going after that particular market at this point. But at some juncture we may well see that happening. Companies such as Covad, Rhythms and Northpoint are already provisioning lines. They have got a head start on the RBOCs and thus far, on the regulatory side, things are becoming a little bit easier for these competitive companies to provision lines out of the RBO central offices.?

Priced at $18 at the time of its IPO in January 1999, the company's shares are now trading at over $80. Covad Communications remains an attractive acquisition target, as Bowen explains: ?It would be foolish not to view them eventually as a take-over target if they do well, much like Teleport which was taken over by AT&T.?

Bowen believes that companies such as Qwest and MCI-WorldCom are more likely than the RBOCs to acquire Covad: ?You probably won't see an acquisition by an RBOC because from the regulatory standpoint, even when they do get 271 intra-latta long-distance entry, they really do not want to perceived by their regulators as snapping up their competition. The whole idea is to promote competition in the local exchange market. But, for somebody like an AT&T, Qwest, MCI-WorldCom which will possibly become very serious about provisioning xDSL services, there is no doubt in my mind that these companies will get looked at. I am sure they get calls already even in the nascent stages of the industry. Quite frankly, companies such as AT&T, Qwest, MCI-WorldCom will probably wait until they gain more market share and it is a lot cheaper to date, even at these valuations, to purchase a company such as Covad and Northpoint than to build your own.?

In an interview with Global Telecoms Business, the president and CEO of Covad Communications Robert Knowling outlines his vision of the high-speed data market and the steps that the company is taking to achieve the goal of being the leading provider of high-speed access.

Could you tell us about your recently launched "Telesurfer"service? How are you attacking the residential market in the US?

We launched Telesurfer about a month ago. Back when we were doing our IPO, we announced that the consumer launch would take place at the end of 1999 or perhaps in the first quarter of 2000.

A couple of things have happened in the business that made me rethink the proposition. In essence we launched the Telesurfer service to dabble our toe, if you will, into the consumer water space. We look at it as a very disciplined approach.

Only a few of our select partners sell the Telesurfer Service. We are only offering two speeds of high-speed access. We are hoping to gauge consumer interest, learn some intelligence around pricing and some things about back-office operations.

We do believe that over time the consumer will be a large component of our business mix, but we are primarily testing ourselves in the market: my reason for doing so is that we are deploying the networks so rapidly and that we currently have DSLAM capacity. So the incremental cost of adding a consumer to my network, with a high profitability of success in terms of filling the order, made a lot of sense to me.

What are Covad's competitive advantages? How do you see the demand for high-speed data services?

My competitive advantage is quite frankly the speed of deployment of my network. I have a first mover advantage owing to our early leverage of the Telecommunications Act. Let me outline the process to illustrate why we have this first mover advantage.

First you have to obtain CLEC status: secondly you have to get inter-connection agreements with the incumbent local carriers. Then you have to pick an equipment platform, deploy equipment, hire employees and resolve a number of other business issues. This process takes anywhere from 12-24 months, depending on the territory. It is not easy. I still do not have inter-connection agreements from two telcos and we have been in inter-connection agreement discussions and negotiations for over two years. Anybody wanting to be a clone of Covad has these barriers to entry. This is just a function of the regulatory process to enter this business. So our first mover advantage is very important.

In addition, the central office of a telephone company does not have infinite capacity to co-locate equipment and there is a tremendous backlog in terms of the telco's ability to allow CLECs to obtain space. So if you are waiting to get your status in terms of CLEC, inter-connection agreements and others, you go to the back of the line. It truly is a process of first come, first served.

Most importantly, unlike the telcos, when we move within a territory, we provide blanket coverage in the area. Blanket coverage means that we will go into 90% of the central offices within that area. For example, look at the San Francisco region. We will not only cover the city of San Francisco, but also 35 miles north of San Francisco, the East Bay and 50-60 miles south of San Francisco to cover all Silicon Valley. There are 2.2 million homes and businesses within that footprint. Our network is deployed and we pass over 1.9 million of those subscribers.

So blanket coverage is a tremendous advantage when we deal with Internet service providers, as they don't need to look at a Swiss cheese map to determine where Covad has coverage. The telcos are not going to deploy pervasive coverage, at least from my experience so far. They are basically going to cherrypick and only deploy DSL in high-density consumer, high-end residential communities.

In your opinion, what are the benefits of DSL technology? Could you tell us about the network you are building? When will it be complete?

The key benefit of DSL is that it is the most economic choice in terms of high-speed bandwidth deployment. When you look at the cost characteristics of satellite, wireless and cable modems, the DSL model is significantly cheaper to deploy than any of the others. For example, on average it costs me about $100,000 to equip a central office that serves 40,000 subscribers. From a cable modem standpoint, to have visibility to all 40,000 subscribers, you would literally have to lay infrastructure into all those sub-divisions and business parks that the serving central office is geographically placed to serve.

With DSL technology, I can put a DSLAM in that central office, which allows me to equip every loop with DSL, leveraging and using the infrastructure that is already in the ground and has already been paid for. That is the beauty of the Telecommunications Act of 1996: I can buy that unbundled element, which provides me with a lower deployment cost.

In addition DSL can be deployed rapidly. By the third quarter of this year I will have deployed DSL technology in over 1,000 central offices in the country. That will represent over 25% of the addressable US market.

Regarding cable, let us look at AT&T and TCI. TCI has cable infrastructure that passes somewhere in the neighbourhood of 20% of the addressable market in the US. The upgrade cost for AT&T to equip that cable plant with high-speed access, telephony and others, comes to $6 billion.

And that is not the total upgrade cost: that represents only 40-50% of the upgrade of the cable plant. If you throw on top of that MediaOne, when that acquisition or merger is finalized, AT&T will then own cable franchises that will pass 62 million homes, which amounts to about 50% of the addressable market. This will add several more billion dollars for the upgrade of the MediaOne cable plant. So for some $10 billion over five years you have managed to equip half the addressable market in the US with high-speed access. If you compare the economics of the varying technologies, clearly DSL is the most economic choice.

Which DSL suppliers are you using?

We are using a company called Diamond Lane, which was recently purchased by Nokia. That is one of our principal suppliers. We also use Cisco DSLAMS.

You just said that Covad has a significant first mover to market advantage. How is Covad leveraging that advantage? Do you believe that the company is advantageously positioned, compared to ILECs and CLECs?

The position that we have today is truly an advantage. My business is doubling about every 90 days. The ability to get in market first, get a large footprint, sign up the premier ISPs and go to market with strong marketing within a territory has proven to be a successful model. Quite frankly those who come after me will find it a difficult proposition. Once you have engaged in a strategic framework with an ISP, I think that it really does prohibit the second player from being as effective as you are. You have basically gone in first and have first right of refusal in terms of who you want to work with within a territory.

Compared to the CLECs and the incumbent telcos, the telco is paying a lot of attention to the cable modem players. And their DSL offering is geared towards consumers. And I don't blame them for being focused in that regard.

I came from the telcos. I helped to shape a lot of strategies that are taking place in at least a couple of those companies today. And my point of view is that they have a huge revenue stream with their private line services, their T-1, ISDN, frame relay, fractional T-1. And I do not believe that you are going to see them aggressively cannibalize those high-margin revenue streams.

Covad has over 200 ISPs and 50 corporations as customers. How quickly do you expect these numbers to increase? Presumably you will focus primarily on the small business market, owing to the international requirements of large corporates?

That is correct. We currently have over 200 ISPs deployed and we have both national players, as well as those ISPs that just operate within small regions. We have added over 100 ISPs in the past three months, so growth is fast.

Can you foresee a situation in the future, where you would be competing against your current partners?

I will tell you that we are going to be very disciplined about what we do. If you can build a critical mass business through indirect partners, it then begs the question: why do I need to become an ISP, which will put me competitively against the very people generating the volume? If you think about the leverage of Covad using 25 ISPs in a territory, compared to going clean on the street with my own employees, sheer logic indicates that I am going to reach large amounts of customers more quickly through the indirect model.

When do you expect to go EBITDA positive? Which benchmarking tools do you employ to gauge various efficiency and profit margins?

Our model around EBITDA is that on average it will take about 24 months within a particular region. We have 22 regions that will be deployed this year. We are currently in 11 regions. San Francisco is the region where we have the most experience. And San Francisco will go EBITDA positive in the third quarter of this year.

In terms of benchmarking tools I pay attention to @Home in terms of my financial modelling. When you really parrot back and look at the amount of network deployed, the ramp rate of growth, the capex cost and acquisition cost of a customer, I still believe that we are trading at a discount to them. But I believe that if we can continue to get at least a few quarters under our belt to be able to demonstrate to the street the growth and the targets that are being achieved, I think that gap will be closed.

I don't pay too much attention to the fibre-based CLECs, because we are very different to them. They are voice plays with central offices and other lines of business. So @Home is a more comparable company. We have truly created a new company and a new space. I would say that we are the new hybrid between the Internet analyst and the CLEC analyst in terms of what they are starting to chart. I would go as far as to say that we are more aligned with Internet companies than with traditional CLECs.

You announced in April 1999 plans to issue five million shares of common stock. How will this issue dilute earnings/dividends? When will the issue occur?

Let me explain the reasoning behind the issue. We have a few unnatural shareholders that are in the mix of investors. As a part of the first high-yield deal, warrants were given to the bondholders. Those warrants represent about 5,000,000 shares. On July 22 our lock-up expires and there will be 37 million shares that are theoretically able to go into the market when we reach that date. The majority of those shares are owned by my strategic investors, Warburg Pinkus and Crosspoint. A significant number are held by the founders and employees of the company.

What I am trying to do with this offering - and there are no proceeds that go to the company - is let the warrant holders get out in advance of this lock-out. I am trying to manage the number of shares that have the potential to hit the market all at once that could negatively affect the stock price.

Are you planning to go back to the equity markets in order to raise more funds in the near future? How successful was the IPO in January 1999? How much money did you raise?

I plan to go back to the equity and debt markets, depending on market conditions. The good news is that I have the ability to go to either. Our IPO in January was tremendously successful. We raised $150 million for the company. I think that we priced at $18. I am not sure where the stock price is today. It hovers somewhere between $80-100.

How is your customer strategy going to change going forward? Who will be Covad's core customers in two or three years?

I believe that you will see the continuation of the indirect wholesale model of Covad, with a tremendous amount of volume coming through indirect channels. At the same time you will see other entities bringing customers to the network. I believe that over the next two to three years you are going to see a number of different industries and sectors start to understand the benefit and the growth of the Internet and how the Internet transforms these industries.

For example, the banking and health care industries are going to transform themselves. You will see major players that will not only facilitate the growth of DSL, but start to partner and in fact subsidize the high-speed connection, once these segments start to understand how they can change the professional services of doctors, health care suppliers and bankers. Just look at what is starting to happen in the investment banking world. E-trade is just growing in leaps and bounds to the point where there is even consideration of allowing Internet trading around the clock every day.

I remember how just a year ago I could call my Schwab investment broker and we could talk for 20 minutes about quotes and a number of different things. Today you cannot reach a Schwab broker. In fact the announcements on the network will tell you that there will be a lengthy hold. If you want to hold, they will even tell you that it will be a 20-minute hold. But then they will say that you have access to the Internet, where you can actually transcribe and conduct business.

I think that you will see entire businesses shift. And when they shift, they will start to facilitate the acceleration of lots of high-speed access over digital subscriber lines.

Do you aim to target the consumer market? If so, how will you claw back the head start enjoyed by cable modem providers, such as @Home, which has already secured about 350,000 subscribers in the US?

Let us be bold and give them 1,000,000 customers. There are 55 million Internet users today. By 2001 there will be well over 120 million users. So from my viewpoint, there is a huge opportunity in terms of the available, addressable market that one can entice one way or another through cable modem or DSL. In the next two or three years it is not the issue of which technology the consumer will choose. The more immediate issue concerns what is available.

Are you planning to offer voice services in the near future? How do you view the voice over DSL debate?

We are looking at voice. We are experimenting with voice. Voice over DSL is not a future technology: it exists today. The question for us is not will we do it, the question is when. We are aggressively looking at it: we are talking to a number of partners. We will be ready to make an announcement one day relative to our entry into that particular field, as we offer voice services over DSL. I think that is going to make DSL terribly exciting, when you start to add enhanced capabilities to the service. The DSL pipe, if you will, has the ability to do a number of different things from a content perspective that just enhances the value of the DSL connection.

Concerns have been raised about the potential speed of your offerings for long-distance traffic, compared to the reach of the incumbents. You are currently using a modified type of xDSL which is compatible with ISDN to gain access to customers that cannot be reached using higher-speed xDSL. How will you resolve this issue?

DSL is distance-limited to about 18,000ft for the higher speeds. For anybody over 18,000ft we offer an IDSN equivalent, called IDSL. Covad's IDSL product is far superior to ISDN. Let me take you through the profile of those two technologies. ISDN is 128kbt, but it is not true 128, because you get degradation of that bandwidth speed. ISDN is not an always-on service. It is a dial-up service. ISDN has an installation charge of anywhere between $700-1,000. There is also a monthly recurrent charge of anywhere between $100-500, depending on how much of a user you are, as this is a service almost like pay-per-view.

If you look at the Covad 144kbt service, there is no degradation of the bandwidth - it is always on and is secure - the installation cost ranges between $400-600 and at retail Covad's recurrent monthly fee is $95. With my ISP partners and the volume that they can buy, the cost of that service can be reduced to the $49-59 a month recurrent fee. So if you stack those two services up, I have a far superior service than the telco offering.

From a technology standpoint, the industry will solve the problem of the limitations and reach of DSL. The second problem you face concerns DSL through a digital loop carrier. I can actually get through the digital loop carrier with my IDSL product. But I believe that we will be talking a year from now about a digital loop carrier being a moot point. The business community will solve that technology hitch.

The management team of Covad comprises a mix of technology and communications expertise, which represents a break from the traditional base of telco-only executives. What are the advantages of such a mixed management team?

Well, it is by design at Covad that we have gone and looked at the mix that we need to be effective in this space. First of all we really are an Internet-based company. So we felt that it is critically important to find people from the data communications and computer industries. We have people on our senior team that were literally giants in those fields, from Intel, Adobe, Sun Micro Systems and Lotus. So we have a fair share of people who truly understand the Internet, have been vital players in key companies in terms of the emerging technologies around PCs, chip technology, software development and other areas.

Now at the end of the day from an operating standpoint we run a phone company. So we have brought that element in from an operational perspective. I have discovered, as I look across the industry at other CLECs - and I have said this to the folks on Wall Street - that I have assembled here at Covad probably one of the strongest teams that you will find in the industry. It is by far one of the greatest assets that we have. I often believe that it is one of the reasons why we have been successful: I have people who were senior executives in those respective industries and know the space, know how to navigate, can easily get into strategic partnerships, talk at the executive level and understand how to grow businesses.

There has been a lot of investor interest in DSL start-up stocks such as Covad, Rhythms NetConnections and NorthPoint. Why do you think there has been such hype surrounding these stocks? In your opinion what has accelerated the popularity of DSL as a technology?

Well I think that you have actually touched upon the answers. DSL has actually been around for about 10 years. The telcos have been talking about DSL for the past six years. You have companies such as Rhythms, NorthPoint and Covad, which have literally taken all the hype around high-speed access, digital subscriber line technology and we have literally gone out and delivered on it. I believe that if you look at those three companies and analyse where they are in their development curves, clearly Covad is the leader. We have a nine-eighteen month advantage over those two firms. And I believe that the street is absolutely in love with the fact that we are closely in line with the Internet. In fact the bottleneck problems of the Internet are being solved by these companies, which are bringing this new technology to the market. It is terribly exciting.

How do you differentiate your strategy from Rhythms NetConnections and Northpoint? Rhythms is already saying that 10-15% of their customers are using 1MB speed and above? Is the demand for these high speeds out there?

Well the sweet spot that we have seen has been 384kbt. We have not seen the demand and interest of customers that want 1.5MB, 4MB, 6MB. We just haven't seen such demand.

How does my strategy differ from those two? From what I know about Northpoint, they are a wholesale player. I am not so sure that you will see them going after the remote LAN business of large Fortune 1000 companies. They could be in that space, but Covad doesn't run into them here. However, if you look at the numbers, I think that they have about 3,000 subscribers. I can't really tell if there is a mix of retail, as well as wholesale, in their business plan.

I do see Northpoint in the ISP space. I will be in a market talking with an ISP and inadvertently they will say that they have received such and such prices from Northpoint. So my sales force does run into the Northpoint gang.

Rhythms on the other hand, according to their first quarter report, has about 1,200 subscribers. I think that they are more of an integrated player, where they are doing more than just DSL. They are doing managed data services, PBX extension. They are doing a number of things, which are in my opinion difficult to do. But I don't run into them in the market very much yet.

When do you think that the voice quality of Internet telephony will be indistinguishable from that of traditional voice telephony?

This is an interesting area I have listened to voice over ATM and voice over IP. And I have to tell you that the quality of the service is as good as anything that I have ever seen. I believe that voice over ATM is going to be a huge play. Currently I think that it is the better of the two in terms of the quality of the service, just in the voice quality. But voice over IP is going to be big as well. And I think that both those capabilities are going to be tremendous threats to the telcos.

Surely the Bells are likely to capture a large proportion of your market share with their own DSL offerings?

I think that they are going to be terribly successful in the consumer space with no marketing, just because they are telcos. But again, if you look at my strategy, a 4-5% success rate in a market allows Covad to build a $1 billion business enterprise. So we don't have to go out and win 30-40% share of the high-speed game. That is the wonderful news about the business model. You have two factors that are working. Firstly Internet usage is still growing by a multiple of ten. Secondly you have a technology where Covad has a first mover advantage in terms of its ability to enter the market first. Thirdly, the telcos are going to focus primarily on the consumer space, because I do not believe that they will cannibalize those high-end revenue streams that we talked about earlier.

In some regards, I believe that there is going to be a lot of room at the table. There are going to be multiple winners. I do not believe the folks who write on this particular topic that there is going to be an ultimate winner. I think that they are wrong. A number of businesses will be created, which will build a lot of shareholder value, as there is that much opportunity to seize.

What are your hopes and ambitions for the company over the next five years? Do you have any growth projections for the company? Where will Covad be on the US telecoms landscape? What trends do you see emerging in US telecoms in this time frame?

My hopes and ambitions for the company over the next five years are for Covad to become the household word in this country when people start talking about high-speed access and enhanced value-added services. Today the darlings in the space are companies such as AOL and @Home. We need to make sure that there is a tripod and that people start talking about Covad in the same breath. So I want to build a brand and company that is truly viewed as the number one provider of high-speed access on the earth. That is a pretty bold statement, but I believe absolutely that we can enjoy that spot.

I am not really permitted to talk about growth projections. But James Henry from Bear Stearns has modelled out where we will be in five years. His five-year model shows well over 1,000,000 customers in five years and a free cash flow business that has revenue of over $1 billion. Those are his models. I believe that those are public documents.

Finally consolidation is the trend that I see emerging in telecoms. Unfortunately, five years from now I think that you will only have three big telcos. It is pretty clear that AT&T will be one of those three. It is clear a south-western Bell will be another.

And at least in my opinion MCI WorldCom will be the other big telco. So what does that say for the Bell Atlantic's and US West's and Sprint's of the world? I don't know. But I think that you will see a lot of great, big players in five years. Maybe in five years AOL will be one of those big players.

Is there anything that you would like to add?

There is one thing that I would like to re-iterate in terms of more in-depth understanding about the management team. In addition to the management team we talked about, we have grown this company to about 450 employees. And we have really brought in some outstanding talent in marketing and operations.

The infrastructure and foundation that you need to really drive business growth are in place, because we have the people in the company who have been there. We have true marketing talent in the business and not telecoms marketing. We are talking about people who have come from the software space, from the PC industry, people who understand indirect marketing, how to generate demand and other issues. This allows us to have a better army and better arsenal than most of our competitors.