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What Does the Future Hold for Pure-Play ISPs?

Pure-play ISPs are going to have an uphill battle competing with incumbent telecommunications and cable providers in the residential broadband market, but many of them have an ace up their sleeves, according to a new report published by The Yankee Group Tuesday.

"For the past year and a half, the major consumer ISPs have been publicly discussing their plans to launch into the broadband market and revolutionize the consumer Internet experience," the report, Winning Residential Broadband Subscribers: Do Pure-Play ISPs Stand a Chance?, said.

"However, to date only a couple of pure-play ISPs have made any progress in the broadband space, while the cable companies and Regional Bell Operating Companies (RBOCs) have take advantage of their deep pockets, political ties, and existing infrastructure and customer relationships to leap ahead of the ISPs that initially whet the consumer appetite for high-speed access. Once dominant in the consumer Internet sector, pure-play ISPs led by AOL, EarthLink, MSN, Prodigy, and Juno now face increasing competition from much larger competitors and are forced to reassess their long-term plans for winning residential subscribers."

AOL, now a unit of AOL Time Warner, has neatly side-stepped that issue by acquiring Time Warner, the second-largest cable company in the U.S. But the report says other pure-plays are facing a tougher time, especially as the RBOCs are now pursuing a strategy of bundling Internet access with their local and long-distance services.

"The category leaders of 2000 -- @Home for cable and Prodigy for DSL -- appear less solid in 2001, as the Bells leverage their strength to move more aggressively in the DSL space and open access becomes an issue for high-speed cable providers," the report said.

In addition to their more aggressive movements in the dial-up market, the RBOCs hold a number of cards when it comes to broadband. Regional Bells like Verizon, BellSouth and Qwest own their networks, and most importantly -- according to the report -- they own the last-mile connection to the consumers they serve.

"This means they don't have to worry about the headaches other ISPs encounter when leasing lines and arranging for technical services during provisioning," the report said.

By bundling access with local and long-distance telephony services, the RBOCs can put together a very attractive package. For instance, BellSouth has pursued such a strategy through its BellSouth Complete Choice package, which consolidates the services and offers a $9.95 per month discount on DSL service.

However, the news is not all bad for pure-plays. They are experienced in an area that most cable companies and RBOCs are not -- content.

"They have either developed or aggregated very robust content solutions," Rob Lancaster, Internet Market Strategies analyst for The Yankee Group and author of the report, told InternetNews.com. "Most of the Bell operating companies just don't have the know-how or the resources to handle that."

The X-factor in this is what types of content will actually drive the acceptance of broadband.

"Ultimately, it's going to be things like music and video-on-demand," Lancaster said, adding that packages targeted at different segments -- like sports fans or gamers -- are likely to be popular.

To capitalize on their varied strengths, Lancaster suggested that the future will hold a wave of partnerships between pure-plays and incumbents who each have something to offer the other, along the lines of the deals EarthLink and Juno have signed to offer their services on Time Warner's cable network.

Indeed, many ISPs are pursuing a strategy of being "access-agnostic," or offering customers a variety of access methods from cable broadband and DSL to mobile and fixed wireless.

"However, the "everything to everyone" model is a dangerous one on which to base an Internet business, and only the largest of the large will be able to succeed using it," the report said. "Others must pursue a more specific, targeted marketing strategy, identifying key markets and selling aggressively to them."

For some ISPs, that could mean staying out of the broadband market altogether.

"It depends on the size of the ISP," Lancaster said. "ISPs that want to compete on a national level, they need to align themselves with broadband providers. The way things are shaping up so far, the regional Bells and the MSOs have an upper hand over the ISPs because they control the access. National ISPs need to continue to develop content that they believe will be attractive to their subscribers over a broadband connection. [But] there needs to be a very conscious decision as to whether or not it makes sense to offer broadband service going forward. Currently, margins [in broadband] are zero or very low, depending on the structure of the relationship. For the smaller, local ISPs, that's going to be a challenge."

Instead, Lancaster said those smaller ISPs could comfortably and profitably remain dial-up providers.

"The dial-up market is going to remain large and there's going to be plenty of dial-up customers to go around," he said. "There is definitely a migration from dial-up to broadband right now. There will be a shift in the imbalance between dial-up and broadband, but there will always be a dial-up market."

The report added, "Dial-up is not a terrible place for an ISP to be, especially if it caters to a niche market and has a loyal group of subscribers who aren't likely to move to broadband in large quantities. The relatively high margins from a dial-up offering and potential referral deals that may be struck with other ISPs that do offer broadband can result in a lucrative business for an ISP, as long as it maintains its vision and sticks to its plan."

The Yankee Group predicts that between 2001 and 2005, the number of U.S. households online will increase from 62.9 million to 80 million, while the households online with broadband access will increase from 10.7 million to 31.1 million. That's a shift from 9 percent of the total online households at year-end 2000 to 39 percent in 2005. But because the overall growth rate will not be as pronounced, many ISPs will have to cannibalize their existing dial-up customers (a fair margin segment) to up sell them to broadband (a zero to low margin segment as noted earlier).

In the case of EarthLink, which has aggressively marketed its DSL service, that pattern has already begun to assert itself.

"EarthLink's success in converting existing dial-up customers to broadband may be coming at a price," the report said. "In recent quarters, EarthLink actually decreased its number of dial-up customers, mainly due to its aggressive up-sell strategy and the advanced nature of its subscribers."

Still, the report noted that EarthLink's decision to aggressively market DSL was a strategic business decision. "EarthLink positions itself as an advanced service provider, as opposed to the family-oriented AOL and MSN, and has assembled -- either organically or through acquisition -- a subscriber base that is very interested in making the move to broadband access," the report said. "Recognizing this early, EarthLink was able to build its DSL offering, satisfy the needs of its customers, and effectively put an end to high churn rates that were occurring due to its lack of a broadband offering."

In essence, then, the report suggests that ISPs need to pay close attention to who their subscribers are and what they want out of their service before settling on a strategy for dealing with broadband.

"In the long term, ISPs must evaluate their position in the market and ask themselves what kind of provider they want to be," the report said. "To launch a broadband service half-heartedly can mean the end for any ISP that isn't among the nation's largest. The costs associated with developing the back-end provisioning, customer service, and billing technologies, not to mention costs of purchasing wholesale access from a cable or DSL provider, can be enormous to an ISP.

"A quick look at its existing subscriber base will tell an ISP much of what it needs to know about its future as a service provider. ISPs must understand who their subscribers are: How long have they been online? Where do they live? How much money do they make? Do they have families? How long do they spend online each time they log on? What kinds of activities do they participate in while online? Do they host a personal or perhaps small business Web site? With this kind of knowledge in hand, an ISP can determine whether it will launch into the high-speed access world, or whether it will remain a narrowband provider."