By Brian Graney (TMF Panic)
June 16, 2000

National wholesale broadband services provider Covad Technologies (Nasdaq: COVD) caused a minor earthquake in the DSL arena today by agreeing to acquire privately held small- and medium-sized business DSL provider BlueStar Communications for about $202 million in stock, based on yesterday's closing price. While DSL consolidation had been expected to occur at some point, this was not the kind of deal that had been anticipated. Other broadband wholesalers -- such as NorthPoint Communications (Nasdaq: NPNT) , Rhythms NetConnections (Nasdaq: RTHM) , and DSL.net (Nasdaq: DSLN) -- all fell on the aftershocks of the news. For its part, Covad dropped nearly 30% this morning, reducing the price tag of the deal to around $145 million.

The sour reaction to the news can probably be chalked up to the fact that Covad's name had been kicked around in a great deal of acquisition chatter over the past month or so, only from the point of view as a likely target rather than a buyer. In a Bloomberg interview last month, CFO Tim Laehy dismissed the takeover talk, saying that a recent drop in the company's share price would not ensure a good buyout value for shareholders. "If we are going to be acquired, I want it to be at a value that I think is real," Laehy stated.

Strangely, the low share price argument didn't hold the company back from using its stock as currency today. Even before this morning's drop, Covad's shares were off more than 60% from their early-March high. If management believes that stock is so undervalued from a buyout perspective, then why in the world would they agree to trade away a chunk of the company -- which is really what is going on in a stock-based transaction -- at a depressed valuation?

While little insight into that question was given in the press release, Covad did try to explain the merger as a way of speeding up its nationwide rollout of high-speed, "always on" broadband data services. Adding BlueStar gets Covad to within a copper strand of its oft-stated goal of reaching 40% of U.S. homes and 45% of businesses by the end of this year, and builds on a line-sharing agreement signed this spring between Covad and incumbent local exchange carrier BellSouth (NYSE: BLS) .

Those arguments failed to convince investors, who may have been put off by the business differences between BlueStar and Covad. Size is a glaring factor, with analysts at CIBC World Markets stating in a report last month that BlueStar had a mere 428 access lines installed compared to Covad's 100,000 lines. Like Covad, BlueStar is targeting small- and medium-sized businesses who are looking for reliable online connections at a faster speed than slowpoke dial-up access, but at a cheaper cost than a super-speedy T-1 line. However, BlueStar serves secondary and tertiary markets in the Southeast U.S. such as Montgomery, Alabama and Greenville, South Carolina rather than the top-tier metropolitan service areas (MSAs) upon which Covad had been focusing most of its growth thus far.

But perhaps the most interesting aspect of the deal is that BlueStar will get Covad back into the retail DSL scene from which it first began. Eventually, Covad abandoned the retail area for its current wholesaling model. While hard to read at this stage of the broadband game, moving back into retail and, in essence, "owning the customer" again may be an early attempt by Covad to hedge against the day that the last mile of bandwidth ceases to be major the bottleneck problem that it is today.

When such a day arrives, add-on services and brand-based reliability may become more important to business and household customers than the form the pipe takes, whether it be DSL or cable or even broadband satellite. Investors looking at the best places in the broadband sector to park their money for the next few years need to keep these changing dynamics in mind.

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