Covad: On the road to recovery

Just six months ago the once high-flying provider of fast Internet access looked like it would join its dying peers in the DSL (digital subscriber line) business. Covad's growth was slowing, and the company was consuming more than $3 million daily while hardly making a dent in a $1.4 billion debt load. Financial analysts had stopped following the company and the Nasdaq national market had just delisted the stock--which still trades on the over-the-counter bulletin board--and many observers were writing off Covad along with rivals NorthPoint Communications and Rhythms NetConnections as victims of a market slowdown and Baby Bell intransigence.

Now it looks like Covad may have survived the worst, courtesy of a bankruptcy deal that enabled the company to restructure its finances. Investment analysts are sniffing around the stock again, and company executives are starting to reappear at events such as this week's Robertson Stephens technology conference in San Francisco. And the customer base is still growing, albeit more slowly than before.

Covad may not be the success envisioned by its once-euphoric shareholders who saw the company's stock price in the mid $60 range in early 2000. It still faces challenges from Baby Bells and new legislation that will come to a House vote Wednesday. But a dose of Chapter 11 bankruptcy, a shot of Wall Street humility, a new CEO and the disappearance of competitors have at least lifted the company's gloom.

"We came out tremendously and further ahead than I ever would have expected us to be," said Charles McMinn, founder and chairman of Covad.

Covad has emerged from Chapter 11 and says it has enough cash to reach profitability without any more help from Wall Street. The company's long-term debt has been virtually erased, and shares, if not robust, have at least climbed from the penny-stock range they occupied from June to November to $1.74 as of Tuesday's close. Wall Street has been paying attention--on an average day, traders move more than 1 million Covad shares, which is very heavy volume for an over-the-counter stock.

Why Covad's bankruptcy worked
Covad survived largely because it convinced bondholders to accept cash and a 15 percent stake in the company in lieu of the original debt agreement. Under the new deal, Covad's creditors agreed to take 19 cents for every dollar owed. "You have to tell them that they take that or they get nothing," said Chris Stuttard, editor with BankruptcyData.com, a research firm. "At least they're getting something."

Part of its new debt agreement required Covad to file for Chapter 11 bankruptcy to gain time it would need to convince the rest of Covad's creditors to go along with the debt deal. Such "pre-packaged" bankruptcies, in which all the details are already known before the bankruptcy, tend to be shorter and more successful than normal Chapter 11 events, Studdard said.

Although the bankruptcy agreement let Covad erase its debt, the company still faced a liquidity crunch. The company was down to $205 million in cash and short-term investments by the end of September, while facing a burn rate of almost $70 million per quarter.

So Covad ran to its biggest shareholder and asked for a loan. SBC Communications, owner of a 5 percent stake in Covad, lent $50 million to the company last fall and agreed to pay $75 million immediately for future services. SBC also paid $10 million to get out of a previous deal and waived a $15 million marketing fee that Covad owed. Covad ended 2001 with $290 million cash, or enough to keep the company solvent until the middle of next year at its current burn rate of less than $60 million per quarter.

Common enemy
The fact that Baby Bell SBC loaned money to Covad, which tries to attract customers by offering better services than the Baby Bells, illustrates the convoluted nature of the DSL game.

Although the two companies compete, SBC and other Baby Bells can benefit from helping Covad, analysts said.

Regardless of the actual DSL provider, Bell companies earn money from every digital subscriber line because they own the central switching offices and the copper lines that connect them to individual buildings. Covad said it pays an average of $5 a month to lease a line already used for voice, and $20 per month for additional lines.

And SBC will be able to point to Covad as proof of competition when government regulators take a look at the telecom industry. Microsoft helped prop up Apple with an investment in 1997, ensuring that Microsoft could cite competitors when accused of being a monopoly. Covad could offer a similar scenario for SBC.

But the biggest reason to help Covad is common self-interest, said Jean-Christophe Deverines, analyst with Frost & Sullivan, a market research and consulting firm. The primary threat to the Baby Bells' broadband plans isn't Covad, but cable companies, Deverines said. Cable modem users outnumber DSL customers by a wide margin, but DSL usage improves in markets where there is more than one major DSL provider.

"SBC realizes that it needs partnerships," Deverines said. "Without DLECs (data local-exchange carriers) or CLECs (competitive local exchange carriers), DSL is not going to fly...They're not friends, but they know their main enemy is cable modems."

Last company standing?
Covad is far from recovering its status as a Wall Street darling, but at least one brokerage analyst believes Covad is worth another look.

"Covad is well positioned to become the leading pure-play broadband provider," wrote Kaufman Bros. analyst Vik Grover, who last month started covering Covad with a "buy" rating.

Of course, it's not hard to lead if you're the only one left.

In recent months, every other publicly traded "pure" broadband company has disappeared. NorthPoint and Rhythms went bankrupt and sold most of their assets to AT&T and Worldcom respectively. Cable modem service provider Excite@Home shut down as well.

"One of the best things that can happen is to be the last man standing," Deverines said. "Or the first man standing up again."

National telecom providers and competitive local exchange carriers--which buy about 90 percent of Covad's lines and resell them--want a nationwide alternative to the Baby Bells. So Covad can benefit from its lonely role, some observers said. However, Yankee Group analyst Matt Davis believes that viewpoint overlooks smaller, regional DSL providers, the Baby Bells' own DSL operations, and, perhaps most important, the communications providers' internal expansion.

Even without NorthPoint, Rhythms and Excite@Home, Covad has some kind of competition in virtually all of its markets, Davis said. "This perceived vacuum of competition is a fiction," Davis said.

Uneasy alliances
The relationships between Covad and the Baby Bells remain uneasy, although it varies by company. McMinn characterized SBC as "much easier" to work with and Verizon Communications as "lousy."

Baby Bells are lobbying heavily for a congressional bill that would remove certain rules requiring them to share their networks with other broadband companies. Virtually all the Bells' competitors, including Covad, oppose the legislation, scheduled for a vote Wednesday in the House of Representatives. Covad issued a statement Tuesday arguing that the "broadband bill," or HR 1542, will be shot down in the Senate.

Dhruv Khanna, executive vice president and general counsel of Covad, said the bill is "ultimately doomed," but if it passes Covad will still be able to provide service. Under the Telecommunications Act of 1996, phone companies have an obligation to provide non-discriminatory access to their networks.

But even if the bill dies, Covad isn't home free.

Covad could be shut out as some of its largest wholesale customers build their own DSL capability, Davis said. AT&T and Worldcom purchased the assets of NorthPoint and Rhythms, respectively, giving the two telecom giants space in many central switching offices.

"We definitely have seen a move to owning your own facilities and owning the customer," Davis said. "AT&T and Worldcom may prefer Covad in a wholesaling scenario, but where you're looking to build your own facilities, you don't need Covad."

The company has already been forced to scale back expectations from SBC, which had been its largest guaranteed customer. SBC's loan last year may have kept Covad alive, but the new agreement also replaced a deal that had guaranteed $600 million in revenue to Covad over six years.

Unfortunately for Covad, most of that money wasn't due until the final years of the contract, and the DSL provider needed the money immediately. "It was a very pragmatic reason to do the (new) deal with SBC," said Martha Sessums, Covad spokeswoman.

Relief from SBC meant sacrificing long-term revenue for short-term survival. But many service providers that might have expanded their own DSL networks to compete with or replace Covad cut back on spending. "Most of Covad's competitors are in disarray, have exited the market, or pulled back on their broadband deployment plans," Grover wrote.

Promise of profits
McMinn believes the broadband market will support more than just one or two companies.

Covad's network increased to 351,000 lines in the December quarter, up 1 percent from September and up 28 percent from 274,000 in the fourth quarter of 2000. Most of that improvement was fueled by market growth, not customers from other broadband companies, McMinn said.

Covad's ability to keep growing despite its financial problems and the overall economic recession indicates there's plenty of demand in the market, McMinn said.

Regardless of the actual level of competition, Covad still must answer a more fundamental question: Can high-speed Internet access be profitable for anyone? Covad's cost cuts won't matter if the company can't improve drastically on its latest quarterly report, which included an operating loss of $108 million on revenue of $85 million.

The economic recession and spending reductions in the communications industry haven't changed McMinn's thinking on the business potential for DSL. Covad, which concentrates on the 50 largest U.S. metropolitan markets, is still sticking to its original goal of being profitable by the second half of next year. Forty of those markets already produce more cash than they consume, McMinn said.

But some analysts believe the plan is flawed. Although prices for DSL have risen in recent months as Wall Street pressured communications companies to focus on profits, Internet access in the long run simply isn't a high margin business by itself, Davis said.

"We examined that model in late '99 and we came to the conclusion that you couldn't really make it work selling dumb pipes," he said. "It commoditized much quicker than they anticipated. You have to have some value-added services with it...They will have to do something to generate more revenue."

Covad has started selling other services besides basic DSL access, including T1 lines and managed VPN/firewall security. They're relatively new offerings, so it's too early to say how much money they'll make, McMinn said.

No matter how those products fare in the market, there is money to be made from basic DSL, Sessums said. DSL prices generally range from $39 to $49 per month for residential lines, which leaves an average of $19 to $29 in monthly fees to be divided between the ISP and Covad once leasing costs are subtracted.

A bad year hasn't shaken McMinn's belief in Covad's original plan, which assumes it will take two years for a new market to produce cash earnings.

"It's not like we changed our expectations as to when these cities would become cash-flow positive," McMinn said. "There'll be plenty of customers for everybody...We're going to add more subscribers. That's all we have to do to get this business to profitability."