Broadband’s Utility Player

Business 2.0: City Telecom, a Hong Kong company that offers 100 megabits per second–65 times as fast as a typical DSL connection–for just $25 a month, with no phone or cable strings attached. Ricky Wong, founder and chief executive of City Telecom, describes his company as “a broadband utility.” Read On…

Gorilla in the mist

By Om Malik

Like aging heavyweights, Lucent Technologies and Nortel Networks are on the mat, bloodied by the telecom downturn. Fans of Cisco Systems are hoping that this is Cisco’s chance to mop up in the telecom carrier market and become the undisputed king of networking. It could happen, but if anybody thinks it’s going to be easy, they’ve got a nasty surprise waiting for them. It’s called Alcatel.

In light of the Worldcom debacle, and continuing cutbacks in carrier capital expenditures, the contention might seem laughable. After all, in late June, Alcatel announced that it would register an operating loss–not a profit as previously projected–in 2002, and was planning 10,000 fresh job cuts. The stock plunged to a 13-year low of $6.98 a share. Beyond its short-term troubles, however, Alcatel is well-positioned to take the top spot.

The Paris-based company has $21.8 billion in sales (more than Cisco, Lucent, or Nortel) and a dominant position selling equipment in Europe and Asia. The only place Alcatel lacks a big toehold is North America, where Lucent and Nortel have locked it out of lucrative relations with the Baby Bells.

With North America accounting for some 50 percent of global telecom equipment revenue–about $100 billion in 2002, according to RHK, a South San Francisco, California, research group–it’s a market Alcatel is again preparing to go after.

Despite the overall revenue comparison, Alcatel ranks second in telecom sales. The company’s telecom business–including optical gear, PBX systems, and DSL modems–accounts for just 74 percent, or roughly $16.1 billion, of its sales. Lucent and Nortel have telecom sales of $18.1 billion and $14.7 billion, respectively.

Still, Alcatel’s $16.1 billion feels safer than the others’ rapidly vanishing streams of revenue. Alcatel’s sales were down just 5 percent in 2001, while Lucent and Nortel saw revenue decline 14.5 percent and 42 percent, respectively. In its September 1999 quarter, Alcatel’s gross margins were 35.2 percent. Since then, they’ve declined slightly, to 33.9 percent; Lucent and Nortel, on the other hand, have seen margins plummet from 49.7 and 45.5 percent, respectively, to just 22.9 and 19.3 percent.

In light of its competitors’ troubles, it’s time for Alcatel to make a move. With analysts, executives, and investors clamoring for consolidation in the industry, Alcatel is an obvious acquirer–a category with fewer members than you might think. Kevin Slocum, an analyst with the SoundView Technology Group, thinks Alcatel, Cisco, and Siemens could be out shopping for the likes of Corvis, Redback Networks, Riverstone Networks, and Sycamore Networks.

But back to Cisco. Although CEO John Chambers has been droning on about how the company is spending half its research and development dollars on carrier-related equipment, talk is cheap: Cisco has little to show for those efforts. It still doesn’t have even basic products–like optical cross connects–that carriers want. And efforts to buy its way in by funding next-generation carriers like Velocita and Sigma Networks have been a flop. To date, sales to telecom companies account for a mere 15 percent of the company’s $18.4 billion in annual sales.

Of course, Alcatel has had its own troubles busting a move. Recall the last aggressive bid to increase its share, when CEO Serge Tchuruk made a $35 billion offer for Lucent in May 2001. That deal fell apart because Lucent wanted to call it a merger of equals, but Alcatel saw it as an acquisition. It’s beyond us to explain how such details could derail a deal, but we’re talking about a pairing of French and Americans here–kind of like drinking an ’82 Bordeaux with your Big Mac. Sacre bleu!

But that’s the past. These days, unstinting support from the French government and European banks has Alcatel ready to take another shot. It’s unlikely it will make another run at either Lucent or Nortel, but that’s probably for the best. Instead, Alcatel is pursuing selective acquisitions to fill holes in its product portfolio.

What are they after? First, Alcatel needs products targeted at the network “edge,” a market likely to see near-term growth. Edge devices normally help act as bridges between two different kinds of networks–like asynchronous transfer mode (ATM) and ethernet.

Alcatel is also focused on technologies that extend the life of the Baby Bells’ current infrastructure. In January, the company bought Astral Point Communications for $135 million. Astral Point’s technology gives Baby Bells’ ATM and synchronous optical network gear an optical makeover.

Since carriers are eyeing the gigabit ethernet services business, one can bet that Alcatel will be there, too. That might be why networking circles were abuzz in May with rumors that Alcatel might be kicking the tires at Riverstone, a maker of ethernet switches and routers.

David Gross, an analyst with Communications Industry Researchers, thinks Alcatel could also sign deals with some startups. Nokia, for example, recently invested $36 million for a 10 percent stake in ailing communications equipment maker Redback Networks and the right to resell Redback products. Alcatel is rumored to be contemplating such a deal with Redback as well.

While Lucent and Nortel flail away, and Cisco keeps on talking, Alcatel is actually the company to watch in telecom equipment. When the telecom winter finally ends, don’t be surprised to see the Frenchmen at the head of the pack.

Originally published in Red Herring

Sargasso Sea

Red Herring :: August 2002 ::If you’re a company executive looking forward to innovative, next-generation broadband services, you might want to pull up a chair. You’re in for a long wait. Why? Because cash-strapped Baby Bell phone companies, like SBC Communications, Verizon, and BellSouth, are too stingy to invest in new network technologies to deliver those services.

In an industry that’s had an insatiable appetite for new technologies over the past few years, this may sound like telecom heresy. But the grim reality has sunk in, and the options are to buckle down and keep costs low, to reduce debt, or to face extinction. “The situation today is similar to the Sargasso Sea: there is no current, no wind, and no waves,” says Allan Tumolillo, chief operating officer of the market research consultancy Probe Research, referring to an area in the Atlantic Ocean where current and atmospheric conditions cause stagnation. “Nothing is going to change for some time,” he adds. “We will drift until 2004.”

Baby Bells and other large players, like Sprint and AT&T, are looking to keep cash-flow positive and thus protect their credit ratings. Many carriers were scared by the pending collapse of WorldCom. Within a week of the company’s debt being downgraded to junk status late this spring, its stock sank below $2 a share (Nasdaq: WCOM). At press time, it was trading for considerably less than $1. Any downward revision on their credit ratings means companies will have to pay more in interest costs, which in turn has an adverse impact on their earnings. “There is a complete lack of faith in the telecom sector, and EBITDA [earnings before interest, taxes, depreciation, and amortization] has become meaningless; everyone is looking for cash flow-positive companies,” says Mr. Tumolillo.

PROCEED WITH CAUTIONLarge telecom carriers are very cautious about investing in new technologies to deliver broadband services. Among the offerings that most observers say will shape the marketplace in the long term are wavelength service, bandwidth on demand, and video on demand.

Wavelength service enables business customers to set aside dedicated bandwidth, assigned to them by their service provider, for specific business purposes, like teleconferencing or large marketing efforts.

Bandwidth on demand is a more dynamic service in which a telecom carrier sells a business customer the right to order large network circuits between two or more points whenever they’re needed. With bandwidth on demand, the customer is assigned a specific color band, or wavelength of light, on an optical network. The ability to order bandwidth only when it’s necessary helps companies avoid costly, long-term fixed contracts for bandwidth.

The much-ballyhooed video on demand, or the delivery of streaming video to an individual Web browser, has faced several technological problems, including clumsy archival features and a lack of adequate bandwidth. The carrier Qwest Communications shut down its Qwest Digital Media operations because of lackluster customer demand and huge debt problems. Earlier this year, Enron Broadband Services bailed out of the business altogether (and a lot of other businesses, as well).

That’s why carriers are sticking with proven, cost-effective moneymakers like T1-circuit (a dedicated connection over which data can be transmitted at 1.5 Mbps, or 30 times faster than a dial-up connection), frame relay (a high-speed packet-switching protocol used in wide area networks, or WANs), and DSL technologies, as well as plain old voice services. Mr. Tumolillo says the Baby Bells, which are eager to cut costs, will continue to sell traditional services like T1 and to make as much profit as possible, since most of their equipment has already been depreciated on their balance sheets. In the coming months, spending on fancy new technologies will continue to drop sharply, as carriers looking for a clear path to profits turn to existing technologies like voice over IP (VOIP), virtual private networks (VPNs), and ethernet over copper.

From Genuity to AT&T, almost all carriers have some sort of VOIP initiative in the works. But it will be a while before this technology has a meaningful impact on their revenue. And VOIP isn’t without its shortcomings. Poor quality of service and problems with packet loss and delays are issues that worry large companies–no one wants choppy or dropped calls, so corporations have been sticking to traditional voice services.

Optimists like Steven Blumenthal, chief technology officer with Genuity, a telecom service provider in Woburn, Massachusetts, are betting that VOIP will be especially attractive to large corporations that need to communicate with multiple international locations within WANs, in which VOIP has proven to be quite effective. VOIP allows large multinationals to circumvent the local switched networks and can save about 17 percent in communications costs within the first 12 months alone, according to the research firm Current Analysis.

Similar economic arguments are being made for VPNs. According to a recent study by the research firm IDC, the total market for IP-based VPN services in the United States will grow from just more than $5.4 billion in 2001 to nearly $14.7 billion in 2006, an annual growth rate of 22 percent. As an increasing percentage of the workforce becomes mobile, most companies are looking for ways to cut costs and still provide their employees with secure access to the corporate networks. While frame relay has been a traditional option, many say that VPNs are cheaper and easier to deploy and manage.

Since carriers are looking to make deep cuts in their operational expenses, which sometimes account for nearly 50 percent of total costs, ethernet over copper is an easier-to-run option, compared to, say, optical networks, DSL, or even T1 technologies. As a primary carrier of data, ethernet over copper could replace DSL in the small and medium-size business markets, which are looking for more bandwidth but refuse to spend $600 a month for a T1 connection.

TELECOM HANGOVERThe telecom industry is paying for its excesses. From 1996 to 2000, telecom carriers of all shapes and sizes spent billions of dollars on new equipment and networks that crisscrossed the globe. The perceived demand for bandwidth, which according to some estimates was doubling every three months, prompted an enormous investment frenzy in infrastructure, the likes of which hadn’t been seen since the railroad boom at the turn of the 20th century.

So what do these dire market conditions mean for startups, and even established players, that were expecting to get new orders for state-of-the-art technology? They aren’t likely to win big orders for their products anytime soon–that is, unless the technology permits the carrier to get a quick return on investment. “It will be two years before the startups get any real orders,” says Greg Blonder, general partner with Morgenthaler Ventures, a venture capital firm based in Menlo Park, California.

The only new technology that might prove successful is ethernet over copper, since it helps Baby Bells compete more aggressively with the cable companies that have started eating into their T1-related revenue.

The indifference toward new technology in the telecom market is a huge concern for large service providers like Genuity, which looks to carriers to provide services that it can then package for sale to its base of 5,000 corporate customers. “There is a fair amount of capacity at both the optical and IP layers, and our focus is on consuming that capacity,” says Mr. Blumenthal. Genuity is also keeping its expenses low, and is interested in service offerings that provide a quick return on investment.

Mr. Blumenthal’s cautious approach is supported by data from RHK, a market research firm in South San Francisco, California, which expects North American telecom capital expenditure in 2002 to fall to between $46 billion and $51 billion, from $77 billion in 2001. And the expenditure level is expected to remain flat throughout 2003. To put things in perspective, two years ago carriers spent more than double their current capital expenditure budgets–a whopping $108 billion–on equipment purchases.

The consensus among research groups is that the first signs of recovery for the telecom industry should begin sometime in 2004. Some observers even say that time frame might be too optimistic. That’s a long time on hold.

Sigma Networks goes dark

Red Herring: We are not surprised that Sigma Networks in San Jose, California, is being liquidated. When the communications company launched in February 2001, Red Herring said its business model was highly suspect and limited in scope–it provided connectivity between telecom hotels (where phone companies lease space to put their equipment) in U.S. metropolitan areas.

Sigma’s strategy was to lease dark fiber from firms like Metromedia Fiber Network, instead of building its own network. In one sense the plan was smart, given that there was already enough fiber in the ground to meet demand. But the model had no barriers to entry–anybody else could lease fiber and mimic Sigma’s operation. Moreover, when the company launched, the market already was fraught with competition: Baby Bells, competitive local exchange carriers, and pure-play data providers like Telseon and Yipes Communications were jostling for the same customers. Sigma’s expected business failed to materialize.

It raised a stunning $155 million in equity investment from the likes of Frontenac, Benchmark Capital, Epoch Partners, Oak Investment Partners, and Salomon Smith Barney. It also raised $290 million in debt, primarily in vendor financing from Cisco Systems, Comdisco, and EMC.

One crucial reason Sigma was able to raise all that money is because its chairman was Reed Hundt, the former chairman of the U.S. Federal Communications Commission. But neither star power nor almost half-a-billion dollars in financing could help Sigma make its way to profitability. In January 2002, the company ceased operations.

Originally published in Red Herring issue dated March 13, 2002

Virtela Takes a Soft Approach to Fiber-Optic Networks.

December 6, 2001

AFTER USING hardware to help build two of the five major Internet backbones, the cofounders of Virtela Communications figured, for their next network, it was time to turn to software.

On the surface, Virtela, a two-year-old startup in Greenwood Village, Colorado, appears to be yet another developer of virtual private networks (VPNs), which connect two points over public networks in a secure manner. It links companies’ branch offices and headquarters over any type of network–frame relay, x25, DSL, or T-1. But the company distinguishes itself by offering additional services on its virtual network, like video on demand, virtual security, and voice over IP.

The cost of building networks has sent companies like 360networks and PSINet into bankruptcy. Instead of building an expensive fiber-optic network, Virtela leases bandwidth from network owners like Qwest Communications. It uses software to connect its networks’ Internet access points (points of presence) to emulate the performance of an optical network. The company only pays for the bandwidth it uses, and its virtual pipe expands and contracts as demand fluctuates.

“In the IP world, the models that will succeed will be the ones which do not throw billions of dollars at the problem,” says Vab Goel, the chairman and CEO of Virtela, and one of the original architects of the Sprint and Qwest networks. He says Virtela spends about $3 million per year to maintain its virtual network; a comparable physical network would cost about $50 million annually.

Virtela officials say that their network can provide television-quality videoconferencing at about 750 Kbps, and the company is offering unlimited videoconferencing services for $4,000 a month. By comparison, an ISDN-based videoconference can cost $800 for about 30 minutes. Videoconferencing may be more appealing in the wake of the September 11 terrorist attacks, as companies use it as a substitute for business travel.

But Virtela’s most promising product may be its voice-over-IP technology, which lets companies connect phone systems in disparate offices. By routing all voice calls over an inexpensive IP backbone, companies can save–in some cases between 50 and 80 percent–on long-distance telephone calls, says Mr. Goel.

Virtela has impressed a stellar lineup of investors. Among those that have pumped a total of $75 million into the company in two rounds are New Enterprise Associates, Norwest Venture Partners, Palomar Ventures, RSA Ventures, Symantec, and Juniper Networks, all of which are heartened that the company has a dozen paying customers.

Don Green Reigns as the Don of Optical Networking

Red Herring, 30 September 2001

In the rough-and-tumble world of optical networking, all fibers stop at Don Green. He may not have the cachet of Vinod Khosla or George Gilder, but Mr. Green’s influence and effect on the telecom industry is infinite. In Petaluma, California, a city of 50,000 located 35 miles north of San Francisco, the shy and reclusive Mr. Green is a revered figure.

He is the chairman of Advanced Fibre Communications, a publicly traded company in Petaluma with $417 million in sales last year. But shunning publicity, Mr. Green would rather talk about the new Donald & Maureen Green Music Center he is helping to build at Sonoma State University in nearby Rohnert Park than discuss his involvement with the telecom business.

His reticence belies the contributions he has made to the telecom industry and the development of “telecom valley,” the region north of San Francisco that extends from Novato to Santa Rosa alongside Highway 101. While the excesses of the past few years may have taken the wind out of telecom’s sails, Mr. Green is confident that telecom valley will continue on its course.

You can find his entrepreneurial DNA in many of the area’s startups, like Turin Networks, Network Photonics, and Cierra Photonics–where he sits on the boards of directors–and in Mahi Networks, founded by his former partner, John Webley. Mr. Green was also an early backer of Fiberlane Communications, which eventually split into Cerent and Siara Systems, two startups that together sold for more than $12 billion to Cisco Systems and Redback Networks, respectively.

Mr. Green’s current perch at the top of the networking ladder is a far cry from the early days when he used to climb telephone poles to fix wires for British Telecom, in order to pay his college tuition. Born in Liverpool, England, Mr. Green immigrated to Canada in 1956, and then to the United States in 1960.

Soon he was working for RCA Standard Telephone Cables–at that time, one of the few companies where an impressionable scientific mind could find answers. “I loved the telecom business, but I did not want to be a bureaucrat,” he says. “This business is too interesting and intense not to take part in it. You can call it a love affair.”

At the end of the ’60s, Mr. Green founded Digital Telephone Systems (DTS) in San Rafael, California. At the time, he couldn’t get a dollar from VCs. “When I started off, no one was willing to fund a company that was going to compete with AT&T and target the regional Bell companies as customers,” he says. DTS, which developed digital local loop equipment for phone companies, was sold in 1974 for about $25 million to Farinon of San Carlos, California, and later merged with Harris Corporation, a communications equipment company now based in Melbourne, Florida.

After six years at Harris, he took the plunge again and started Optilink in 1986 with numerous friends from DTS. Four years later, when Texas-based DSC Communications acquired Optilink (and was later acquired by Alcatel), Mr. Green retired. But within 18 months, former colleagues and DSC alumni John Webley and Jim Hoeck persuaded him to cofound Advanced Fibre Communications.

Mr. Green has developed the capability of translating technology within picoseconds into viable business ideas, says Mr. Webley. His Rolodex has been compared to a master key to all the locks in the telecom business, and that makes him special for any startup getting off the ground. The British emigrant spends nearly four hours a day dispensing advice to the half-dozen startups he is involved with. “I’ve learned a lot, and if startups want to listen, I can help them avoid some of the pitfalls and obstacles that you tend to run into,” he says. No wonder Mr. Green is considered the don of optical networking.

Write to [email protected]

Data centers run for cover

This article appears in the June 1, 2001, issue of Red Herring magazine.

At the height of the dot-com boom, one business was even more fashionable than the half-witted e-tailers: data centers. As venture capitalists pumped billions of dollars into e-commerce startups, those companies developed a sudden need for a place to outsource their servers and bandwidth. Exodus Communications (Nasdaq: EXDS), which had been a struggling ISP, jumped onto this bandwagon, and others like Equinix (Nasdaq: EQIX), Globix (Nasdaq: GBIX), and NaviSite (Nasdaq: NAVI) quickly followed suit. Data-center revenue boomed from $941 million in 1999 to $3.5 billion in 2000.

But now, as the industry faces a slowing economy and the demise of free-spending dot-com ventures, the party’s over. The recent entry of large telecommunications companies like AT&T (NYSE: T), Qwest Communications (NYSE: Q), and WorldCom (Nasdaq: WCOM) into this market is making the data-center business a price game that only the flush can play. Meanwhile, demand is shifting in favor of managed services provided by startups like Avasta, Intira, and Loudcloud (Nasdaq: LDCL).

Data centers, also called co-locaters, rent equipment, space, and bandwidth to companies that don’t want to host their own Web sites. Managed services companies take this concept one step further and maintain Internet infrastructure for large companies. While many data-center companies offer managed services, their primary revenue comes from co-location.

Data-center companies have drastically increased their capacity: by the end of 2003, their worldwide gross square footage will jump nearly ten times, to 83.6 million, and the number of data centers will grow tenfold, according to Tier 1 Research, a market research firm. But that growth has been funded by debt, and companies now are watching their cash reserves empty and their debt burdens increase.

DEBT CENTER For example, the San Francisco brokerage WR Hambrecht estimates that Exodus will have to shell out about $365 million, or 20 percent of estimated revenue, in interest expense on its $2.8 billion in long-term debt. In 2002, expect that number to hit $400 million, which means Exodus may have to raise more funds from the capital markets.

And the capacity brought by that debt may go unused. According to Tier 1, dot-coms represented a third of hosting revenue in 2000, and as startups go under, data-center companies’ business is drying up; Exodus, for example, recently lost two premier tenants, eToys and Pets.com. The company this past week said it would lay off 15 percent of its workforce in an effort to cut costs.

In the meantime, the data-center business has attracted deep-pocketed giants like AT&T, Qwest, and WorldCom that are bent on taking market share away from existing players. As those companies see some of their core businesses — like consumer long distance — wither, they are looking for new ways to derive revenue from their existing networks. Because companies like AT&T and Qwest own networks, they can afford to sell services at lower prices to attract customers — a luxury that data-center companies cannot afford. Besides, corporations are more likely to choose big players, not small companies, for their outsourcing, says Tier 1 founder Andrew Schroepfer. And while the outsourcing business retains its long-term appeal, at the moment corporations looking to cut IT spending are delaying plans to outsource infrastructure.

The telecommunications stalwarts are serious about using data centers to increase their flat-lining revenue streams. In 2000, both Qwest and UUNet (a division of WorldCom) nearly doubled the number of their data centers; by 2002, AT&T plans to have 44 data centers. Existing players that have mounds of debt to pay off will find it tough to play the price game.

Increasing cash reserves won’t be easy, given that data centers generate so few dollars per square foot. Tier 1 Research data shows that average annual revenue for pure co-location services is $216 per square foot. By comparison, Wal-Mart’s (NYSE: WMT) 376.5 million square feet in the United States generated $133 billion in 2000, or roughly $355 per square foot. Translation: Wal-Mart did much better by selling paper towels, soap, and other sundries than it could have by running a data center, which, theoretically, is a high-margin venture. Tier 1 estimates that a data center running at full capacity needs to generate $808 per square foot in its first year to break even.

On the other hand, managed-services companies, like Loudcloud and Avasta, can generate up to $2,500 per square foot. Ironically, those companies rent space from co-locaters, and since they have no overhead, they have a better business model. Even if data-center companies shifted their focus to managed services, it would be a few years before they could compete with existing players like IBM (NYSE: IBM) and EDS (NYSE: EDS).

“This is a challenging time to be in the co-location business, because the new players are telcos who have deep pockets,” says Greg Gore, an analyst at WR Hambrecht. “It is turning into a volume game, and the players with the deepest pockets will win.” Tier 1’s Mr. Schroepfer predicts a shakeout among the first-generation companies, followed by a period of consolidation. “Telcos were the fools a few years ago,” he says, “and now they have all the cash.” Already WorldCom has snapped up Digex (Nasdaq: DIGX), and a recent report speculated that Cable & Wireless (NYSE: CWP) may acquire Exodus.

At this rate, unless data centers quickly increase their reliance on managed services, formerly foolish telcos could sweep in and buy existing players for pennies on the dollar.

Write to [email protected]

One to watch: Dangerous devices

Former disciples of Apple Computer (Nasdaq: AAPL) CEO Steve Jobs keep trying to invent cool new devices that they hope will become as popular as the Macintosh. Apple alumni have gone on to start companies like WebTV Networks, TiVo (Nasdaq: TIVO), and now Danger Research, which has raised $10 million in initial funding from Softbank.

In a Silicon Valley clouded by dismay and despondency, Palo Alto-based Danger could prove to be a ray of sunshine. Founded last year by president and CEO Andy Rubin, chief technology officer Joe Britt, and senior vice president of hardware and operations Matt Hershenson, the company is building a wireless email device that the trio hopes will displace Research In Motion‘s (Nasdaq: RIMM) popular Blackberry device. Not shy about admitting that Blackberry was his inspiration, Mr. Rubin says, “RIM did it right, and we are emulating it.”

But Danger isn’t the only company trying to build a Blackberry-type email device. Others like Good Technology of Redwood City, California, and Motorola (NYSE: MOT) are also building gizmos that let users send and receive wireless email.

The RIM-envy is justified, because investment bank Morgan Stanley Dean Witter has forecasted that in five years the U.S. interactive mobile wireless industry will yield $15 billion in annual revenue and in ten years that figure will jump to $60 billion. International Data Corporation, a market research firm, expects that shipments of smart handheld devices (including Blackberry-type devices and personal digital assistants) will grow from 12.9 million units in 2000 to more than 63.4 million units by 2004.

DANGER’S LIAISONS RIM’s Blackberry has a strong presence in the corporate market. Danger is targeting the consumer market — a wise move, despite lower margins, as demand there is much higher. For instance, Motorola has sold more than a million of its Talkabout radio devices, which are favored by glitterati like Los Angeles Laker Shaquille O’Neal, rapper Jay-Z, and MTV heartthrob Carson Daly. “I don’t think that the Blackberry will appeal to consumers, as consumers want more than email,” says Tim Scannell, an analyst with the research firm Mobile Insights. “Consumers want wireless Web, instant messaging, and email, and they don’t want to spend $500 for a device.”

Danger hopes to price its device somewhere between $150 and $200, making it much cheaper than the $400-plus Blackberry. Mr. Britt believes that the company’s products, expected to ship this fall, will be ideal for wireless carriers building next-generation networks that can support data rates higher than the current 19.2 Kbps.

A prototype made available to Red Herring included a calendar, an address book, a memo pad, and Web browsing software. The cigarette pack-size device, which supports electronic games and applications like stock tracking, also has a small keyboard.

“With our device, you can actually see any HTML-based Web page,” boasts Mr. Britt, who previously developed operating systems at 3DO, Apple, Catapult, and WebTV. The process involves rendering the pages on Danger’s server, Mr. Britt says. The company’s server software does the heavy lifting; the device locally caches only small portions of data — for example, an address book.

“And the fun part is, if you lose your device, you can buy a new device and restore everything,” says Mr. Rubin. For that alone, Danger will be worth buying.

Write to [email protected]. The article appeared in the June 15, 2001 issue of Red Herring. 

Jilted by broadband

When Microsoft was developing the Xbox video game console in 1999, consumers were signing up for high-speed Internet access as quickly as they could. Seduced by this growth in broadband subscriptions, Microsoft made a critical decision. The device would be equipped with a broadband ethernet connection–instead of a conventional dial-up modem–for online games and other services. The company’s choice was driven by a desire to reserve the Xbox for games with high-quality graphics that would require high-speed data transmission. By implication, it was a nod to what many thought would soon be reality: ubiquitous broadband.

Three years later, Microsoft’s broadband-or-nothing decision looks premature. Only 8 percent of U.S. households–some 10.5 million–have a broadband connection, but 58 million households have a dial-up connection. And the rate of growth in the number of broadband subscriptions is flattening; it’s been 15 to 20 percent per quarter over the last two quarters, compared with almost 100 percent per quarter in 1999. Before the Xbox release last fall, Microsoft’s CEO, Steve Ballmer, tacitly acknowledged the looming problem to the European press. “We have grown more pessimistic about this than we were a few years ago,” he said. “It [broadband] has proceeded more slowly than we expected.”

Meanwhile, Microsoft has yet to launch its online game service, Xbox Online (the company says the first games will debut this summer). And the ethernet connections, which cost the company about $5 per console, have yet to be used. “The strategy for Internet gaming is dependent on broadband capability. It is possible that some won’t buy the Xbox because they don’t have broadband capability,” admits Mr. Ballmer.

Microsoft isn’t the only technology company that broadband has left at the altar. Other companies that made bets on widespread broadband are giants like Intel and Apple Computer, startups like the set-top box maker Moxi Digital and the broadband content production house Trapeze, and scores more, representing a cross section of the beleaguered technology industry (see “Left in the Lurch . . .” page 49). Sony, for instance, is embedding an IP address in the software of practically every electronic device it manufactures–Walkmans, televisions, cameras, PlayStations–and making them broadband ready. “But I don’t think that broadband will reach the broader market until late 2003 to 2005,” says Kunitake Ando, the president and chief operating officer of Sony.

In its most basic form, broadband is an always-on online connection with data-transfer speeds faster than those of dial-up modems. But the future of broadband promises more than just faster Web surfing. Increase the speed of data transmissions well beyond what most people use today and software applications, semiconductors, communications equipment, computers, and devices will keep pace. That is why continued growth in broadband usage matters: it will drive the next wave of technology innovation and investment. Without a surge in broadband subscriptions, the technology industry, and possibly the economy as a whole (which throughout the ’90s was driven by technology growth), has little chance of recovery in 2002.

It seems that everyone–tech industry players, politicians, and economists–has been pinning their hopes on ubiquitous broadband. But those companies that are best positioned to provide new broadband subscriptions–incumbent telephone companies like SBC Communications, Verizon, and AT&T that control “last mile” access to customers’ homes–are content with mere incremental growth. This situation provides an opportunity for startups to offer a cheaper way to give people high-speed Internet access. They’d better get it right–and soon.

Recognizing this, the technology industry’s national trade group, TechNet, is calling for a national effort to provide broadband connections. In January, the group announced a goal of having 100 million homes connected at 50 times the fastest current rate by 2010. John Chambers, the president and CEO of Cisco Systems and a TechNet member, says this effort is a priority for all technology companies that is as important as was the race to put a man on the moon.

“We sit here in 2002 in a recession,” says John Doerr, a partner at the VC firm Kleiner Perkins Caufield & Byers and a TechNet member. “The widespread deployment of broadband will increase the efficiency of Americans at work and at home; that is why this is so important.”

Politicians are also hailing broadband as a cure-all. In his economic stimulus speech before Congress in January, U.S. Senate majority leader Tom Daschle (D: South Dakota) called for the creation of “tax credits, grants, and loans to make broadband service as universal tomorrow as telephone access is today.” The argument is that an increase in the number of broadband subscriptions will lead to increased sales of online services, chips, computing hardware, and software applications.

Even some economists say that a wider use of broadband could lead the U.S. economy out of recession. “You don’t have a critical mass of broadband, and for the economy to recover you need to have the pickup of broadband,” says Karen Kornbluh, a Markle Fellow at the New American Foundation, a think tank in Washington, D.C.

Whether or not broadband holds the only key to prosperity, it is almost certain that without a greater number of people using DSL, cable modem, or wireless broadband connections, many technology companies will be left in limbo. Companies that invested heavily in services or products that rely on speedy Internet connections may have made an expensive mistake.

Flat Rates

This is not the way it was supposed to be–just ask Mr. Ballmer or the chip engineers at Intel. The spread of broadband, for a while anyway, seemed unstoppable. At the end of 2000, year-over-year growth in the number of DSL subscribers was 382 percent, according to the research firm TeleChoice. Had that pace been sustained, DSL would be in more than 10 million homes by now. Instead, the latest projection by TeleChoice shows DSL cracking the 10 million mark in mid-2003. The growth rate of the number of DSL subscribers dropped from 87 percent in fourth quarter 2000 to 13 percent in third quarter 2001. Meanwhile, cable-modem subscriber growth rates fell from 19 percent to 8 percent over the same period. And pricey subscription packages and uninspired marketing efforts from cable and telephone companies don’t inspire confidence for a dramatic uptick in the number of broadband customers anytime soon.

Yet almost three-quarters of U.S. households have access to broadband cable, and half can avail themselves of DSL. Among those using a high-speed Internet connection, 5.3 million do so over cable modems and 3.5 million over DSL (see “Off Line,” below). Another 110,000 use some form of high-speed wireless connection, either satellite or fixed wireless, and another 812,000 use Internet TV offerings. Broadband ubiquity depends on winning over the 40 million or so U.S. households currently without an Internet connection and on upgrading those that currently use dial-up.

However, it’s not just new subscribers that broadband’s cheerleaders are hoping for. At an Internet conference in New York last December, Robert Pittman, the co-chief operating officer of AOL Time Warner, estimated that his company’s revenue potential for selling broadband access and other services (that largely don’t yet exist) could go as high as $159 a month per household. That’s quite a bit higher than the $24 per month it charges for dial-up and $40 per month it charges for its Road Runner cable modem service.

Other companies can’t wait for such a future. They need broadband revenue now. RealNetworks’ RealOne, a relaunch of the Seattle company’s GoldPass service, is a prime example of a fledgling broadband service. It’s a subscription service that offers downloadable music and video. The service, which launched in December, has garnered 400,000 subscribers paying $10 per month; it’s relatively successful, but not enough to help the company turn a net profit in 2001.

“For entertainment value there is nothing better than what you can get on digital cable,” admits Mark Hall, vice president of programming for RealNetworks. “Does the Internet compete? The answer is in the numbers, and the answer is no. Broadband is not the heroin-like addictive form of entertainment that television is, but we are only a couple of years into it. The RealOne service that we are offering depends on addictive applications that have yet to be invented.”

And that is a key part of the broadband problem. New applications are needed to entice people to sign up for broadband, but programmers won’t create services for a broadband audience that doesn’t exist. When Napster was free and going full-bore, Internet users everywhere wanted a broadband connection to download music. But free Napster is no more, few new applications are being offered, and broadband’s spread has slowed. Even though companies like RealNetworks and Microsoft have their plans in place, consumers have been given little reason to pay $50 or more per month for a fast connection.

The stranded companies–and the programmers and developers–fault the broadband providers for not signing up more broadband customers. Plans by SBC Communications, Verizon, and Sprint to attract new broadband customers, for instance, have been scaled back or scrapped altogether. The reason, they say, is that almost every broadband customer is a money-losing proposition.

Money Matters

The initial idea was simple, even if the economics were faulty. Broadband customers would connect over the television cables or copper telephone wires that run to their homes. For cable companies, this meant converting their cables to a two-way system. From 1998 to 2001, the ten largest cable companies spent $46 billion on this effort, according to the Yankee Group, a research firm. Other companies, with telecommunications firms leading the pack, spent $90 billion over the last decade to build a cross-continental fiber-optic network. Then the telcos spent even more on the hardware and software needed to make the system work.

It seemed like money well spent. A widely publicized study by Charles Jackson, an independent engineering consultant, and Robert Crandall, an economist at the Brookings Institution, a think tank in Washington, D.C., published last July projected that widespread broadband use could benefit U.S. consumers and producers by as much as $500 billion annually. Greater productivity from faster access to databases and from high-speed communications accounted for the bulk of this benefit. Broadband providers alone would rake in $100 billion annually, the study concluded. Needless to say, those fat revenues have yet to materialize.

Instead, the operating margin for broadband cable, excluding marketing and sales expenses, is about 5 percent. Meanwhile, it is unclear whether or not DSL is profitable for telcos. “Trying to get the true provisioning costs for DSL from an incumbent local exchange carrier is just about an impossible task,” says Pat Hurley, a consultant at TeleChoice. He’s suspicious of U.S. broadband providers claiming poverty while charging $50 or more per month. “Bell Canada charges the equivalent of $28 to $30 per month, and Korea Telecom is charging about the same,” he says. South Koreans are four times more likely to have a high-speed connection than Americans; Canadians are twice as likely. “What it shows is there are providers out there that are pricing aggressively and not going out of business,” says Mr. Hurley.

The economics of broadband should be getting better. DSL providers now claim a 90 to 95 percent success rate for self-installation, which is far cheaper than dispatching a telephone repairman and truck at a cost of up to $1,000 per customer. And gross margins are consequently improving thanks to ever-larger subscription bases.

But not everyone believes the business can be made profitable. “Consumer broadband is failing because the revenue model does not cover the cost,” says Tony Abate, a general partner at the VC firm Battery Ventures. “The only guys who can do it, are the cable guys because they have the [cash rich] video business. As far as DSL, the incumbents are not deploying because even $100 per month does not cover the cost of setting up one customer.”

As a result, many in the industry are eyeing wireless DSL service to deliver broadband in an affordable, yet profitable fashion. The technology (and its economics) works best in rural areas not served by DSL or cable. For example, Prairie iNet, a broadband wireless ISP, has attracted 4,200 customers over the last 18 months in Illinois, Iowa, Nebraska, and Kansas–the flat states.

In much of the United States, however, broadband wireless has run into the same installation problems that plague regular DSL. Take the independent ISP Sonic.net, in Santa Rosa, California. The company has 3,000 broadband customers paying $56 per month, with one-third of them using high-speed connections on a fixed wireless network provisioned by Broadlink, a wireless network equipment maker. “There are a lot of challenges in wireless,” says Dane Jasper, the cofounder, president, and CEO of Sonic.net. “Deployment and scale are tough. Who is going to run the wire inside? Who will drill the hole? Climb the roof or the chimney? There are all these hurdles. And in many cases the equipment is expensive.”

Another challenge for wireless broadband is to circumnavigate every tree and hill for transmission (hence, the technology’s success across the prairie states.). Confronted with these obstacles, Sprint stopped accepting new wireless DSL customers in October. Though Sprint doesn’t reveal subscriber figures, according to analyst estimates, it continues to provide high-speed fixed-wireless Internet access to between 30,000 and 50,000 customers.

Companies that can make broadband profitable for providers and lower the monthly cost for consumers may help businesses that are counting on broadband. AOL Time Warner and Sony, for instance, partnered to offer services like video-on-demand and downloadable music through AOL Time Warner’s cable system. “Broadband is seen as a luxury item by the consumer, and the only way you are going to get the momentum is by taking the prices down to the $30-to-$35-per-month range,” says Mark Kersey, a broadband industry analyst with the research firm ARS. “Twenty-six million Americans pay $25 for AOL. They will not mind paying another $5 for a faster connection.”

The Fix Is In

BroadJump, a startup in Austin, Texas, aims to correct the economics of consumer broadband. Backed by nearly $50 million from investors like Accel Partners and Austin Ventures, the company makes software that helps service providers–cable, DSL, and fixed-wireless operators–get customers connected without deploying field personnel. The company has signed up seven deep-pocketed customers, including BellSouth, Adelphia, and AT&T.

The whole point is to prevent the $1,000 house calls needed to connect new customers. The company’s Virtual Truck product allows consumers to install broadband connections from a CD-ROM. “We can lower the installation costs to between $150 and $500 per customer,” says Kip McClanahan, founder, president, and CEO of BroadJump.

Another Austin startup, Advent Networks, has developed a technology–dubbed Ultraband–as a cheap way to upgrade cable for broadband services. With a souped-up cable box on the consumer end and chip-based software at the cable company office, Advent says its technology sends data 20 times faster than an ordinary cable modem. “We just took the approach that says the cable companies have already spent all this money re-architecting their networks,” says Geoffrey Tudor, Advent’s chairman and CEO. “They don’t want to go out and add more nodes to their networks. They can deploy Ultraband with zero truck rolls.”

With $28 million raised in December 2000 from Motorola and a slew of utility companies including Reliant Energy and Southern Union, Advent now needs to sign up customers. Ultraband is currently being tested by Everest Global Technologies, a Lenexa, Kansas, cable company. A letter of intent also has been signed with an undisclosed Mexican cable company, Mr. Tudor says. If all goes well, the provider will deliver Ultraband service to 450,000 subscribers.

One alternative to DSL and cable broadband is passive optical networking (PON). The service uses optical cables to the home or office and delivers Internet data at speeds more than six times faster than DSL or cable. The problem is that PON is twice as expensive to provision as DSL. Nonetheless, SBC announced last spring that it was going to use PON technology to deliver broadband services to small businesses.

Private-equity bets are already being made on companies developing network equipment that would lower the costs of PON. Alloptic, a startup in Livermore, California, is funded with $32 million from the network hardware company Scientific-Atlanta, the tire manufacturer Pirelli, and VC firms like Athenian Venture Partners and the Blackstone Group. The startup is building a PON device that would help the Baby Bells deliver everything from data to voice and television, for which they can gain enough incremental revenue to make PON-based broadband profitable at $50 per month.

Other companies are attempting to fix broadband cable’s inherent problems, like the way a network slows to a crawl when too many people are using it. Dev Gupta, the founder, president, and CEO of Narad Networks in Westford, Massachusetts, says his company has developed a technology that allows cable operators to send data at speeds of up to 100 Mbps (about 50 times faster than current broadband cable)–and sustain those levels regardless of the number of users.

These startups will be instrumental in forging a healthy consumer market, the stuff of AOL Time Warner’s and Microsoft’s revenue dreams. Steep growth curves for broadband subscriptions could lead to a flurry of new services and applications. But even while these young firms innovate, the subscription growth that many companies need to prosper is not materializing–and the U.S. economy remains stalled. Those companies whose immediate futures depend on broadband everywhere had better look for a different business, or plan on running very lean for the near future.

Nonetheless, some companies have little choice but to execute their broadband plans. Sony is launching a broadband gaming service for the PlayStation 2. The service begins in April, and it is just the start of a strategy to deliver a range of content, from games to music, movies, and financial products, over the Internet.

Meanwhile, Microsoft, which designed its Xbox for a broadband world, also is moving forward in the face of anemic subscriber growth. When Xbox Online launches this summer the gravity of the situation will become clear. Microsoft and others will be desperately seeking a broadband audience.

Michael V. Copeland, a freelance writer based in San Francisco, was formerly a senior writer at Red Herring. Write to [email protected]