A Rule Breaker Sell

Regular readers know that we have had many qualms with our worst-performing holding, Excite@Home (Nasdaq: ATHM). Nevertheless, we've held on, hoping that the company might show some signs of getting back on track. It hasn't. The time has come for us to sell our 900-share stake, which we'll do in the next five trading days.

Why did we buy Excite@Home?
The buy report lays out the full argument for why we saw @Home (before the Excite merger) as a Rule Breaker in December 1998. @Home decisively led the important, emerging industry of cable broadband Internet service -- in fact, @Home invented it. It was clearly the top dog and first-mover in a business that was growing by leaps and bounds.

What's more, since it was majority-owned by a consortium of cable companies and had exclusive contracts with them, we believed that @Home had a sustainable advantage over competitors. Other signs of sustainable advantage were the addictive nature of the product, the momentum of the business, and the weakness of competitive technologies.

Are those factors no longer true?
Generally, they are still true. @Home has a huge lead in the cable Internet service provider (ISP) market. It had 2.3 million subscribers at the end of last quarter. That's more than double the 1.1 million of its nearest direct competitor, Road Runner, which is a joint venture among affiliates of Time Warner (NYSE: TWX), AT&T (NYSE: T), Microsoft (Nasdaq: MSFT), and others. @Home is still the top dog.

The business continues to grow substantially. @Home saw a 28% sequential increase in subscribers last quarter and a 174% increase in the past year. The company expects a 30% sequential increase again this quarter. @Home has the strongest momentum of all the players in the industry.

We still think that broadband ISP is an important, emerging industry. Every day, more music and streaming video appears on the Web, making a fast connection essential. When people get a fast connection, it's addictive and satisfying. Ninety-three percent of @Home's customers say that they are not likely to switch to another ISP. That customer loyalty and the exclusivity agreements @Home still has with its cable partners give @Home a competitive advantage.

There is some question, however, about whether that advantage is sustainable. There's a new player in cable broadband -- fellow Rule Breaker America Online (NYSE: AOL), reigning monarch of ISPs. Today the Federal Trade Commission voted to approve the merger of AOL and Time Warner (NYSE: TWX), on condition that they open access to other ISPs, which is what AOL has wanted all along. In a press release, AOL Time Warner said, "The Companies expect that their commitment to consumer choice embodied in the FTC agreement will become a model for other cable systems throughout the country." If that happens, @Home may find its growth slowing substantially.

Why are we selling Excite@Home?
Part 1: Excite
Other problems are manifold at this company. First, Excite@Home now includes Excite as well as @Home. @Home issued 58 million shares to acquire Excite in May 1999, a deal valued at about $7.2 billion. Let me repeat that number: $7.2 billion. When a company shells out that kind of dinero for a company, it had better be damn sure that it will pay off.

If management thought it would pay off, they were dead wrong. In virtually every way, the merger has been an abject failure. It may have given the ISP a more content-rich portal, but revenue from that portal has remained totally stagnant at around $240 million a year. There's no reason to think that things will get any better, either. Excite has not built its brand at all. It adds no consumer appeal to the @Home ISP.

As a narrowband portal, Excite is no more attractive. Excite operates a free, dial-up ISP called FreeLane with 1.2 million subscribers, putting it 11th among ISPs. CMGI's (Nasdaq: CMGI) 1stup.com had provided FreeLane's platform, but 1stup went belly-up last week. Excite has found another partner, but reviews of the new service on our boards have talked about few local access numbers and busy signals. No one has proven they can make money with a free ISP anyway, so FreeLane's failure may actually help matters. But who wants to own a company where it's better for initiatives to fail than to succeed?

Excite cost a huge amount and added next to nothing. Let us not forget to mention the $1 billion BlueMountain.com acquisition -- $350 million of which was cold, hard cash. Excite@Home paid this sum for a company that produces virtually no revenue and acknowledges that it never will produce meaningful revenue. Ouch.

Why are we selling Excite@Home?
Part 2: Poor management
We praised CEO Tom Jermoluk when we bought the company. While Jermoluk excelled at the broadband business, he had difficulty operating the media branch of the company. In May 2000, George Bell, previously CEO of Excite, replaced Jermoluk. Bell also couldn't make the media branch work. He announced in September that he would step down as CEO as soon as a replacement is found.

We don't, however, place all the blame on either of these gentlemen for all the poor decisions at the company. Unless both are completely schizophrenic, the problem has not purely been their direction, but that there are too many competing voices trying to run the company. AT&T had a 56% voting majority on the board of directors until the recent restructuring, which has given it 74% voting control. Comcast and Cox also own 30 million shares each, which give them a strong voice.

Cable partners have had voting control of @Home since 1998. They also set the prices for the @Home service, of which Excite@Home gets a 35% cut. This is a scenario that creates lots of conflicts among the big owners and management, and the result has been chaos.

First there were the bad mergers. Then came the idea to spin off Excite as a tracking stock. That didn't happen. Then came idea to merge the international properties with UnitedGlobalCom's (Nasdaq: UCOMA) chello broadband. That fell through.

What exactly is the plan here? Right now, the company is being pulled in all different directions. The media division is sucking wind, and there doesn't seem to be a plan to fix it. Not only is there no plan, there's no planner -- the company still hasn't found a replacement for Bell.

The main problem with management, though, is that Excite@Home doesn't control its own destiny. Whoever the CEO is, he has to clear his plans with AT&T. Whatever the plan, cable partners will set prices for @Home's broadband service. With little control over its destiny, Excite@Home can't ever be a Rule Breaker.

In a recent poll, we asked when Excite@Home had jumped the shark (i.e., shown that it would not succeed as previously expected). The poll results said it was when @Home acquired Excite. That was most certainly a blow to the company, but we wonder whether it might have been Day One, when they signed over too much control to their cable partners. We may not have given enough weight to that factor in our original analysis.

Why are we selling now?
You may well be saying, "All of these factors are pretty far in the past. Why are you selling now?" Good question. The answer is that we should have sold earlier. Jeff pointed out back in March that Excite@Home hadn't established a brand for itself and that the company lacked direction. When we discussed the company in September, the conclusion was that we should probably sell. Some board posters thought that, if we did, we would be selling at the bottom. It's fallen almost 70% since then. It turns out that the bottom on this stock is very deep.

It took time to see that Excite was a failure and that management had no direction, but those things have been clear for some time. We acted slowly in response, and we've paid for that poor decision. Even as late as September, if we had sold and shorted an equivalent amount (consider shorting the stocks you sell for business reasons), we'd be back to even. Woulda, coulda, shoulda.

We make lots of mistakes. We try to learn from them and improve, but we need to work on our selling strategy. It's another reason not to mimic us. Look for more discussion of this matter in the future.

We bought @Home a little over two years ago and watched it triple in a few short months. That appreciation seemed to validate our selection. Who knows? Were it not for the ill-advised Excite acquisition in May 1999, maybe @Home could have fulfilled its Rule Breaker potential. As it is, we're walking away with about $6,000, a $19,000 loss. We'll be discussing what we will do with the proceeds next week.

And so we say farewell to Excite@Home. It may well bounce back to the teens. It may get bought out. We don't know what will happen in the short term. We wish it and its shareholders the best of luck in the future. The point of our selling is that Excite@Home doesn't belong in our portfolio. In our opinion, it's not a Rule Breaker.

Let us know what you think in this poll:

What does the future hold for Excite@Home?
a) It will provide market-beating returns as it becomes a Rule Maker.
b) It will track the market as business flows steadily on to profitability.
c) It will continue to flounder until it gets bought out.
d) It will drop further and get bought for pennies per share.
e) I don't know. I just don't want to hear about it ever again.