By John Borland
Staff Writer, CNET News.com
April 25, 2002, 4:00 a.m. PT

In 1993, Sky Dayton was "pulling his hair out" trying to get online--so he bought 10 modems and set up his own Internet service provider, named EarthLink a year later.

In nearly a decade since then, EarthLink Networks has grown into the country's third-largest ISP, trailing only America Online and Microsoft's MSN. But Dayton is still frustrated.

"We're approaching a tipping point where you have to have broadband--where if you don't have it it's like not having running water," said the 30-year-old Internet pioneer. "But we're not there yet."

From its earliest days, EarthLink has consistently helped define what the Internet looks and feels like for millions of people who have resisted signing on with its mega-corporate rivals. Even now, the company is airing television commercials that reinforce its image as a simpler alternative to an advertising-laden online world dominated by AOL.

The company could play an even more significant role as mainstream America graduates from rudimentary dial-up connections to fast Net access, or broadband.

Along with this portentous opportunity, however, EarthLink faces its most serious challenge in years. Although broadband could be exactly what EarthLink needs to finally bridge the gap with AOL and MSN, it remains unclear whether the company's historical advantage of providing no-frills, affordable service will succeed in the difficult business of high-speed Internet connections.

Many industry analysts say EarthLink has a better broadband strategy than its larger competitors. As the first generation of high-speed Net companies like Excite@Home flames out, EarthLink's strategies are already influencing the evolution of the broadband universe--and, in the process, helping to determine the prices and quality of service for the consumers who inhabit it.

"EarthLink is doing fabulously well" against AOL and Microsoft, said Peter DeCaprio, a financial analyst with Thomas Weisel Partners who covers the ISP industry. "I think EarthLink is going to be the de facto national broadband platform in fairly short order."

Yet well before it can claim that mantle, EarthLink must overcome some major obstacles. The company has lost momentum in its core dial-up business while concentrating heavily on broadband, and critics have questioned whether EarthLink has lost the tight focus on quality that established its original reputation.

EarthLinkSucks.net
Already, the company has drawn bitter complaints about its broadband connection speeds and installation work, documented in painstaking detail on such sites as DSLReports and EarthLinkSucks.net.

"We're not proud of some of the experiences our customers went through over the past year and a half," EarthLink Chief Executive Garry Betty conceded. But this year, he said, the company's broadband operations will "evolve to something less like going to the dentist" into what he calls a "testimonial" quality of service.

At the same time, EarthLink continues to encounter problems in its core business. A slowdown in dial-up subscriber growth has weighed down the entire ISP industry but has hit EarthLink particularly hard.

In its quarterly earnings report Monday, the company fell short of Wall Street's expectations and warned that its second-quarter numbers could miss the mark as well. The company was forced to raise prices last year, a move that proved particularly painful for those customers of the cheaper ISPs that EarthLink had purchased.

EarthLink's broadband customers had grown to about 471,000 by the end of 2001, nearly double its number at the end of 2000. But those numbers are deceiving: EarthLink cannibalizes its dial-up customers to enlist broadband subscribers, robbing its old ranks to feed the new.

After reaching 4.4 million dial-up subscribers in mid-2001, the company has reported a decrease to about 4.2 million for the last two quarters. Betty and Dayton have set and missed goals of 5 million subscribers two years in a row.

"The big challenge for them is to hold on to as many of their existing subscribers as they can while they try to migrate to broadband," said Jupiter Media Metrix analyst Dylan Brooks. "Part of the concern is that their dial-up numbers keep sliding...You end up seeing a more significant (cancellation) rate than with a lot of competitors."

Humble beginnings
As disappointing as those numbers might be today, they would have been unthinkable eight years ago, when Sky Dayton was a 22-year-old entrepreneur whose previous work experience rested largely in starting a coffee shop and a graphic design firm in Los Angeles.

Dayton was initially met with considerable skepticism, partly because of his vocal adherence to the controversial Church of Scientology. But he quickly established a good reputation with relatively tech-savvy customers not satisfied with AOL's lowest-common-denominator service.

In the process, he and his executive team revolutionized the ISP business. While AOL, CompuServe and most other large ISPs owned their own data networks to carry traffic, EarthLink bought network time from other companies. This allowed it to shift traffic between different networks as it found cheaper bandwidth prices.

As its subscriber numbers grew, thereby expanding its bargaining power, EarthLink would benefit from playing these networks against each other. For example, it could threaten to shift from AOL's networks to Microsoft's pipelines when the latter charged a lower fee, and vice versa--a strategy that helped cut EarthLink's costs substantially.

Other ISPs followed suit, most prominently with AOL's complicated three-way sale of its own backbone network, and CompuServe's backbone network, to WorldCom.

"It wasn't obvious as an ISP early on that you weren't in the network business," Dayton said. "But time has proved that we had the right model."

Southern comfort
In 1996, Dayton found a new chief operating officer in Betty, a plainspoken Atlanta native who joined the company after a "harrowing" ski trip with the CEO. Betty quickly rose to take the chief executive position himself, taking over much of the company's daily operations.

At that point the company was already national. Over the next few years it expanded largely by buying smaller ISPs and by hatching a deal that let it take over Sprint's dial-up customers. The company recognized that scale would bring costs down.

In interviews from the time, executives spoke of a "dead zone" in dial-up ISP economics between 30,000 and 300,000 subscribers. Once out of that limbo, it was possible to make money.

EarthLink's growth rate was steady; AOL's was explosive. By 1999, the Pasadena, Calif., company decided it needed more, and Dayton again turned to Atlanta. The company merged with MindSpring, forming a solid footing as the largest independent competitor to AOL and MSN.

Even as that merger concluded, and as AOL combined with Time Warner, the ISP business was changing dramatically. Consolidation and basic economics had left only a few companies at the top of the dial-up ISP business.

ISP Darwinism
Those survivors began staking their future on broadband, thinking that fast connections would persuade consumers to sign up for expensive new services such as music subscriptions, video on demand or networked gaming--which ostensibly would give the ISPs a cut of the revenues.

AOL, MSN Net services face off Bruce Kasrel, analyst, Forrester Research October 19, 2001

Sources say EarthLink has been exploring the possibility of creating its own music subscription plan, similar to those operated by MusicNet and Pressplay and distributed on sites such as Yahoo and MSN, though company executives would not confirm this initiative.

Convinced that it had the right formula in its dial-up strategy, EarthLink has taken the same approach to the broadband business in hopes of making network companies compete for its business. It has signed deals with Time Warner and AT&T to use their networks for broadband cable connections.

Analysts say other network companies are likely to court EarthLink for its large subscriber numbers--including Baby Bells that offer DSL (digital subscriber line) service, the main rival to cable--and the ISP will again be able to negotiate with all the broadband wholesalers for the cheapest prices. "I don't see it as any different than what we experienced in dial-up," Betty said.

That could be where he's wrong.

In the dial-up business, telephone companies must let any ISP set up modems and offer connections over regular phone lines. As Internet usage grew, many network providers sprang up to carry data behind the scenes, and their competition helped bring costs down.

High-speed networks work differently. Cable operators aren't required to let other companies offer ISP service over their networks. The Baby Bells must offer use of their DSL lines to other companies, but the price is high, and federal regulators are planning to cut back on regulations that require them to share.

Tight margins
These factors help make broadband a losing financial proposition for companies that don't own the networks themselves. EarthLink pays telephone companies about $35 per month for every DSL subscriber's network connection and about $30 for the equivalent service over cable networks. It charges its own subscribers $49 per month for those connections, barely covering costs for cable and actually losing money on its DSL customers.

Betty maintains that those costs will eventually fall. In 1996, EarthLink paid about $21 a month to service every customer with Net access at $19.95 a month, he said, but costs came down over time to make that a profitable business.

But here again, EarthLink may encounter difficulties in taking its dial-up approach to the broadband market. In the high-speed industry, the network companies themselves--rather than traditional ISPs--may be the strongest rivals to EarthLink.

Because those companies own their networks, they have the ability to offer discounted prices for introductory services or limited speeds. Two such companies, AT&T Broadband and SBC Communications, each have about 1.5 million broadband subscribers already.

		News analysis AOL's high-speed challenge CEO Barry Schuler's departure puts broadband plans in question.

Analysts say AOL in particular is threatened by this kind of broadband menu. Although it owns the nation's second-largest cable network, it has struggled to offer its service on lines run by other companies in different parts of the country. AOL Time Warner says it has 4 million subscribers who "access broadband services" but refuses to break out how many of those are Time Warner Cable customers, how many use DSL, or how many use other connections.

EarthLink executives say they're confident that the cable and telephone companies will ultimately see the value of working with other ISPs, and that they will be no more dominant in broadband than they were in the dial-up business. Analysts also note that the big network companies, which regulators are still scrutinizing for anti-competitive behavior, have an interest in working with EarthLink.

"It behooves the (cable and telephone) companies to have a strong--but not too strong--partner in place," Jupiter's Brooks said. "Those companies have a vested interest in seeing EarthLink be successful. But not too successful."

Even if it can offer competitive prices, EarthLink must still prove to customers that its service is worth buying. A group of California consumers is suing the company, alleging that it badly misrepresented how well it could deliver DSL in its early marketing campaigns.

Nevertheless, in last year's J.D. Powers industrywide survey of consumer satisfaction with ISPs, EarthLink came in a close second place in both the dial-up and high-speed service categories. And in a business as tough as this, many consider that a huge feat.

"Overall, they had a great year," said Steven Kirkey, senior director of telecommunications for J.D. Powers. "They're a real success story."