Fool's Eye View

[ September 28, 2000 ]

Freeserve Struggles To Impress

By

Great Titchfield Street, London -- Ever since Freeserve (LSE: FRE) came to the market back in July 1999 it has struggled to convince investors that it has a viable long-term business. Today's first quarter results, although good in many respects, don't look like they will allay these concerns. The recent troubles of T-Online in Germany and Liberty Surf in France have only made investors even more sceptical.

Unmetered joy?

The unmetered access market is one of Freeserve's big successes at the moment. Its £10 per month deal has attracted 250,000 customers in just five months. Many competitors have withdrawn from this market, which is unprofitable at the moment due to BT's (LSE: BT.A) charging structure. This gives Freeserve a market share of over 50% in the unmetered market and 37% in the overall UK connectivity market, which it says is twice the level of its nearest competitor.

Freeserve says that its unmetered access service will be profitable at the gross level once the charging structure is revamped, which is expected to happen shortly. However, being profitable at the gross level means before all overhead costs. Although it is early days it still looks very unlikely that Freeserve is ever going to generate significant profits from connecting people to the Internet. It is up against some very stiff competition whose pockets are far, far deeper. At the end of the day it is a commodity business and, as such, it unlikely to be that profitable.

Sales quadruple

Freeserve saw its sales leap from £3.4m in the same quarter last year to £14.6m. That's impressive, but it also incurred cost of sales of £4.8m in this period, as opposed to none in the same period last year. So progress at the gross profit level was less impressive. It rose from £3.4m to £9.8m.

But there was also a big leap in expenses from £8.5m to £24.4m. Freeserve spent £13.7m on sales and marketing but was quick to point out that the underlying level of expenditure was actually around £7m with the remaining £6.7m in costs relating to a one-off exercise of rebranding itself as a portal rather than an Internet Service Provider (ISP). This seems a little naïve. Is this rebranding really complete? Many people don't know the difference and don't really care. I suspect that most Internet users still consider Freeserve as an ISP no matter how loudly it shouts "Portal!".

Freeserve still has a very high churn rate and will need to continue to pump money into sales and marketing if it wants to continue growing its customer base. Although active customers topped 2m for the first time this was achieved by adding 612,000 new customers and losing 542,000 existing ones. Although unmetered access has helped reduce the churn rate Freeserve is still losing a quarter of its customer base every three months.

Cash is burning

Talk about cash burn rates is back in vogue again after the recent report by PwC. So how is Freeserve faring on this front? It spent £12m in cash in the past three months but has just £54m in the bank. This means it has a little over a year at current spending levels so a share issue looks likely before too long. It wouldn't be surprising to see expenditure increase in the short term as Freeserve expands into new platforms such as mobile and Internet TV.

As you may have guessed already I am not a Freeserve fan, so I find it difficult to give the business of the benefit of doubt, which its current market value of £2.5b seems to be doing. To succeed it has to make profits in areas other than connectivity, and it is still difficult to see how it is going to make that leap considering the bigger, more experienced companies circling that area as well. Its reliance on the UK, in a business where scale is all-important, is also worrying. And the fact that is has been up for sale for many months with seemingly little interest from others in the marketplace speaks volumes.

Where Next?

Freeserve discussion board