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Summary:

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 […]

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 om.malik@redherring.com.

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