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The Kazaa conundrum
The RIAA's lawsuits have split the broadband ISP industry and will likely split investors as well.
September 10, 2003: 1:15 PM EDT
By Eric Hellweg, CNN/Money Contributing Columnist

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SAN FRANCISCO (CNN/Money) - When I wrote in July about the Recording Industry Association of America's plans to subpoena individual file sharers, I said, "Trust me: It will be one of the biggest stories of the late summer."

I hate it when I'm right. Watched the news lately? Stories of angry citizens under legal siege and 12-year-old defendants fill newscasts and newspapers. The RIAA's response: "No one likes playing the heavy."

That goes for broadband Internet service providers as well. But as the highways over which the majority of file-sharing traffic passes, broadband ISPs now find themselves at a fork.

On the one hand, file sharing is "as close to a broadband killer application as we've got in the U.S.," says Joseph Laszlo, an analyst with Jupiter Research. "The broadband ISPs are smart enough to know they need every killer app they can get to drive demand."

On the other hand, heavy file sharing places a strain on ISPs' resources, with traffic connection costs making up about 25 percent of companies' cash operating expenses.

"Connection cost is a meaningful cost," says Ned Zachar, an analyst with Thomas Weisel Partners. "If the usage would drop, it would reduce companies' connection cost, and they'd get a slight benefit to their margins."

Split reactions

Not surprisingly, broadband ISPs are split on their reaction to the RIAA lawsuits, with some companies fighting the subpoenas and others quietly complying.

The issue divides investors in the broadband space too. Reducing traffic could improve company margins, but a drop in file sharing could also slow broadband adoption. What's more, many of these ISPs are parts of bigger media concerns, so slowing file sharing means protecting assets. As such, investor response to the lawsuits should depend largely on the asset makeup of individual companies.

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One thing's certain: For investors this story is more than a fascinating societal drama; it could have real-world consequences for their portfolios.

Broadband growth has helped ISPs this year, which complements the investor-held belief that more consumers are signing up for broadband and that long-promised additional revenues are finally rolling in. And while most analysts I spoke with cited general utility as the key driver to broadband adoption, file sharing, or "the ability to download large files," as one Jupiter survey worded it, was right behind it.

In fact, 54 percent of respondents to the Jupiter survey cited file sharing as their reason for switching to broadband. And 31 percent of all current broadband customers said they use file-sharing applications.

Worth alienating a third of your customer base?

Thirty-one percent of your customer base is a pretty huge target for lawsuits. Some ISPs, including Verizon (VZ: Research, Estimates) and SBC's (SBC: Research, Estimates) Pacific Bell Internet Services, have decided that they will fight to protect their users, pushing back against the subpoenas issued by the RIAA.

"We haven't complied with any of the subpoenas," says Larry Meyer, a spokesman for SBC Communications. He says the RIAA's actions "raise serious constitutional questions. [They] threaten the privacy rights of customers and all Internet users." The company takes issue with the RIAA's reliance on the Digital Millennium Copyright Act as the basis for the subpoenas.

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Earthlink (ELNK: Research, Estimates) initially resisted the RIAA's efforts last year, but is complying now because Verizon lost its court case against the RIAA earlier this summer. Verizon is appealing that case, and EarthLink will abide by the appellate court's decision, according to a company spokesperson.

Other ISPs have complied with the RIAA's legal efforts. Among those are companies such as Comcast (CMCSK: Research, Estimates) and AOL Time Warner (AOL: Research, Estimates) (parent company of this site).

"AOL has cooperated and complied with the RIAA on these matters and will continue to do so," says Nicholas Graham, a company spokesman. "It's in our interests and obligation under the law." A Comcast representative could not be reached at press time.

None of the companies I spoke with would comment on the motivations behind competitors' actions. But one common denominator appears: The companies that are remaining silent or complying have vested interests in the media being pirated.

AOL Time Warner owns both movie and music companies, and Comcast relies on selling access to video fare for the majority of its revenues. As such, these companies find themselves in the file sharers' crosshairs.

So should ISPs fight for their users' interests and pursue their anti-DMCA legal efforts, or sit quietly by while the RIAA plays the heavy and tries to reduce their traffic costs and protect their media assets? The lines are clearly drawn.

For investors, this battle will produce winners and losers, in both the short and long terms. Any investor who sees this as simply a court case against some college kids does so at his or her own peril.

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