At the height of the dot-com boom, an established Internet service provider was a goldmine. Not only was there a stream of new customers coming online, large cashed-up ISPs were also prepared to pay top dollar to acquire your customer base. Then came a period of mass consolidation as the likes of MCI WorldCom, Asia Online and Austar acquired numerous small ISPs. Some smaller players held out from the lucrative offers hoping demand would climb even higher.
Instead the stock market crashed, and the value of the ISP business plummeted back down to earth, sometimes as low as 15 to 20 per cent of its value from the previous quarter.
While in previous years the number of ISPs in the market fell due to acquisitions, the latest data from the Australian Bureau of Statistics (ABS) suggests small ISPs are pulling out of the market of their own accord. In the March quarter of 2001, 29 of the 31 ISPs that dropped from the market had under 1000subscribers. As one ISP noted, "many are realising it is no longer the sexy industry to be in". However, analysts are not surprised.
"We were expecting a drop off because subscription fees are coming down, so it is harder to make good margins," commented IDC's Lisa Shishido. "The smaller ISPs are now forced to compete on price."
Not so long ago, a small or medium-sized ISP could easily sell out at a reasonable return. Today, however, the larger providers have found new ways of gaining market share without needing to spend any cash. By bundling voice and data services together, the economies of scale can simply price smaller competitors out of the market. "The current economic climate has kept the large ISPs from focusing on acquisitions - instead they are looking to focus on how to increase their revenue per existing subscriber," explained Shishido. "They know they can make more money up-selling and cross-selling services than continuing to spend money acquiring customers."
Analysts and the ISPs themselves note the consolidation is not over and that ISPs need to reinvent their value-add and create completely new service models to stay in business.
Like the IT reseller, the small ISP profits not from the margins it makes on its core product (in this case, Internet access), but from the incremental margins of the value-added services it can wrap around the product. "The actual link with the customer is a low-margin business," said Michael Malone, founder and managing director of ASX-listed ISP iiNet. "The customer service relationship and the billing are usedto offer bundled and differentiatedproducts to get greater margins."
The first value-added services ISPs began offering - Web hosting, domain registration and e-mail - have now become commonplace.
Dennis Muscat, managing director of large ISP Pacific Internet, believes that while the fundamental product of ISP will always be reliable connectivity, ISPs are having to move into managedservices to differentiate themselves.
These managed services could include everything from offering secure gateways, online virus scanning services, browser-based Web applications or even home networking services. It is expected DSL services, the uptake of which is beginning to run many medium-sized ISPs off their feet, will be the key technology for making such services possible.
During the thickest period of acquisitions in the late 1990s, at a time when OzEmail was sold to MCI for a sum equated to over five times OzEmail's revenue, the ISPs most sought were those with between 5000 and 10,000 subscribers. "Every ISP with over 5000 subscribers has been offered money at some stage," said Stuart Marburg, managing director of Melbourne-based ISP, Netspace.
Medium-sized ISPs provided the
necessary points of presence and
relatively large customer bases the acquirers wanted without having to fork out the many millions of dollars.
In addition, medium-sized ISPs sit in what Internode technical director Simon Hacket calls the "sweet spot". The sweet spot is defined by an ISPs purchasing power and the ability to offer personalised service.
Bandwidth has become the kind of commodity that comes at much cheaper prices when purchased in bulk. The fundamental problem for small ISPs is they do not have the purchasing power to buy at cheaper prices and compete with their larger competitors. But if you are large enough to have that purchasing power, but small enough to still offer personalised service, you have achieved a good balance as an ISP. "Soon there is going to be a shake down in the market as to who is serious and who isn't," said Hacket. "If you're not above a certain size, you don't have the purchasing power to get bandwidth at a better price. So there is a real hard ground between the hobbyists and the guys with a few thousand subscribers."
The solution for some ISPs is to join a buying group. A buying group is a collection of service providers banding together to consolidate the purchasing of bandwidth. They are able to pay cheaper prices while maintaining their own independence and differentiation. This is a method proved to be very successful by the TPG group and in recent months the Leading Edge Group, which uses a similar strategy for buying hardware and software on behalf of its IT reseller members.
"You often find ISPs wanting to collaborate to increase their power in the market," said Greg Holloway, managing director and founder of Melbourne ISP Connexus Internet. "They either do that through merging or forming buying groups or using peering exchanges."
Peering exchanges is another way small and medium-sized ISPs are tackling economies of scale. They allow ISPs to exchange traffic with each other at little or no cost. An example of such a collaborative arrangement would be Netspace, which has more points of presence in Victoria than South Australia, and Internode, which has more points of presence in South Australia than Victoria. The two recently formed an agreement whereby they will provide a service to each other's customers in those regions where their partner has more presence. It saves a considerable amount of money to exchange traffic with each other than to call on the network of a major carrier.
The idea of consolidating the buying power of multiple ISPs has also led to the establishment of a franchise model for Internet service provision. The first Australian attempt at such a model ended in disaster when ASX-listed ISP Limited dragged several franchisees down when it fell into administration in May 2000. However a new player in the market is pitching the McDonalds approach to the ISP market as still workable.
Hotkey, a division of Primus (America), recently signed up eight Australian ISPs as franchisees to launch into Australia. Hotkey pays these ISPs an up-front sum to acquire their customer databases while giving them access to a broad range of value-added services each earning Hotkey and the ISP incremental revenue per customer. It also provides them with marketing tools such as TV advertising and promotional CDs.
The catch is although the original ISP owner still owns their business, it can only be sold as a Hotkey franchise. The owner also pays Hotkey a percentage of everything they earn.
According to Hotkey managing director Campbell Sallabank, the franchise model is the only way small ISPs can get out of the trap of trying to compete against businesses with better economies of scale in terms of marketing and purchasing power. "Without a doubt, they are struggling," he said. "They are not necessarily broke, just treading water."
Sallabank suggests the reason that past attempts at the ISP franchise have not been successful in Australia is because they weren't large enough to achieve the necessary economies of scale. He believes Hotkey, backed by the large market share of Primus, has the scale and the mind-share to be a success.
However, following the ISP Limited failure, many ISPs do not see the same value in the model. "In order to do franchise well, you need to have control over the business for brand consistency," said Pacific Internet's Muscat. "As much as it is an interesting concept, it would be a challenge not to over-commoditise the product and lose that key element of personalised service."
Although Pacific Internet acquired several ISPs to scale up its Australian business, Muscat believes organic growth is a less risky and more profitable model for an ambitious ISP. He claims Pacific Internet has doubled the amount of customers it acquired in 1999 through organic growth. This growth was driven by a referral model, where every new customer signing up is offered a bounty to encourage another customer to sign up.
But Sallabank is adamant if it works for McDonalds, it will work for ISPs. "Franchise models have dominated so many other industries and set a real precedent," he said. "There is no fundamental reason why a well-structured, profitable franchise model can't produce a leading player in the ISP market."
If all else fails, it's about service
There are several ISPs that have turned down every offer to be acquired, as they believe that personalised service is the only way any service provider can stay in business. "At the end of the day, the main things we are trying to achieve would be more or less destroyed if we sold out," said Jason Ciotti, general manager of Melbourne ISP Access Net. "In every case there was the possibility that it would remove the human element, and customers would be asked what account number are you?' Any time an ISP worries more about market share than running a reliable service, they are disabling the business."
According to Internode's Hacket, the largest ISPs are often hampered by an inability to differentiate themselves from each other by providing the personal service many customers demand.
"People prefer personal service, to speak to the same people every time" said Netspace managing director Stuart Marburg. "That is something a call centre at a large ISP doesn't always provide."
Access Net, which only serves 2500 subscribers and employs 10 staff, is an example of a small ISP that takes service to the next level. Ciotti said that rather than just provide Internet access, he approaches the business as a consultant. Access Net's staff advise clients on the best way their needs can be met, even if it means referring them to another provider. "It creates a high level of goodwill and trust among our customers," he said. "When customers started enquiring about ADSL, we were guiding them through dealing with Telstra. But they were all telling us, regardless of price, they would stay with us if we offeredit because they know us on a first-name basis."
Telecommunications analyst Paul Budde believes it is this emphasis on customer service above all else that will enable a small ISP to survive on its own. "You may have to be a repairman as well as an ISP," he said. "There needs to be a level of professionalism if the company is going to grow beyond a garage operation. You have to pre-empt the servicesthe market wants and is prepared topay for."
Internode's Hacket said the main issue is that an ISP has to decide whether it wants to be a mass provider of cheap connectivity or a niche provider of quality connectivity. "Often an ISP can afford to be cheaper because they compromise their customers with bottlenecks," he said. "Which is okay, you just have to know which type of ISP you are. The problem is when a cheap ISP pretends they are quality."
- Join a buying group.
- Join a peering exchange.
- Buy into a franchise.
- Provide a personalised customer service.