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Report Paints Bleak Future for Traditional ISPs

An Internet service provider valuation report released this week by Wit Capital Group Inc. predicts doom and gloom for small Internet access providers and recommends that investors be wary of investing in the group.

The report prepared by Elliot S. Prince, Wit Capital managing director, contends competition from free ISPs will put pressure on current dial-up access providers to reduce prices in the consumer segment.

Prince said that the only way ISPs can counter the declining revenues forced by free service pressures is to migrate customers to broadband services or accumulate such a large consumer base that $10 a month unlimited access fees can produce a profitable venture.

"ISPs need to participate in aggressively deploying broadband services to make up for diminished dial-up revenues," Prince said. "We'll see ISPs trying to pick up the contracts for local cable franchises as old licenses like Excite@Home's expire. ISPs will need to be competitive and aggressive to be a provider of choice."

Prince believes that cable Internet service providers are the least likely market segment to be impacted by the free ISP market forces. He also predicts that several private cable deals will be produced in the next six months. In July, the New York Times reported that a deal between AT&T and AOL might be in the works, but the potential transaction remains unsubstantiated.

Prince reviewed the performance of EarthLink Network, Inc., (ELNK) MindSpring Enterprises Inc., (MSPG) FlashNet Communications, (FLAS) OneMain.com (ONEM), Prodigy Communications Corp. (PRGY) and American Online Inc. over the past few years.

Despite the ISPs strong performance in June, an August sell-off indicated that investors' appetites for Internet stocks had been satiated. Prince said the stock market is in a period of downward correction of ISP valuations and that free Internet access offerings would continue to drive the valuation further south.

"We believe that the challenges to the development of incremental revenues and the risk posed by lower dial-up revenues to ISPs gross profits are matters of serious concern," Prince said.

"Large ISPs and those ISPs that can migrate subscribers to broadband services quickly are likely to offset a decline in dial-up revenue. However, we could not expect smaller ISPs to be as successful in the transition."

Marlowe Burke, Wit Capital research analyst, said small ISPs have to migrate services or consolidate to survive in today's marketplace.

"Traditional ISPs can consolidate their services to command e-commerce and residual revenues from advertising monies," Burke said. "But they will also need to add broadband DSL or cable services. It's a matter of migrate or consolidate."

Prince said that small ISPs being able to withstand current market pressures is pessimistic at best.

"We're going to see a lot of consolidation in the industry," Prince said. "We're already seeing the market shift to better prices for ISP buyers than sellers. ISPs that survive will need to create larger, more loyal customer bases."

According to Prince, AOL's 18 million-subscriber base may provide the company with a cushion against the potential downward spiral of dial-up accesses fees and profitability. If AOL begins tolose subscribers due to market forces, they may counter the industry shift by building free access through their Netscape licenses.

In the report, Mike McQuary, MindSpring chief operating officer said that competition from free ISPs will have zero impact on their business model.

Executives from OneMain.com and EarthLink believe that the free services will bring new subscribers online. These new subscribers will in turn, demand greater services than the free entities can provide and naturally migrate to full service providers.

Prince agreed that customers demanding better services would naturally migrate to other access providers like AOL and that many consumers merely utilize the free access as a second means to connect to the Internet. But that does not change the fact that by the end of 1999 free ISPs will represent about 2 percent of the U.S. online market. By the end of 2000, Prince anticipates that free service providers will own 15 percent of the market.

National ISPs have been quick to respond to current market forces by offering long-term Internet access bundled with nearly free personal computers. But buying customer loyalty for a couple years will not stem the flow of consumers seeking high-speed broadband services, unless access upgrades become part of the deal.

Prince contends that the market is entering a transitional period when broadband sales may not offset reduced dial-up access revenues. Because Digital Subscriber Line providers have already reduced pricing to bring service fees in line with cable access services, there may be an interim period when ISP revenues could decline as much as 20 to 40 percent by the end of 2001.

Prince reported that EarthLink was quick to respond to consumer demand for broadband services and has hastened the deployment of their national DSL footprint. The company could be well positioned to benefit from free access customer migration toward high-speed services.

Onemain.com may be sheltered from current market risks, according to Prince. But the ISPs focus on facilities-based rural and small market Internet access may make it ripe for acquisition.

WIT Capital recommends that investors exercise extreme caution with their investments in consumer ISPs until the direction the market is taking become clearly defined.