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Turnstone Business Model Drives up IPO

by Hal Plotkin
Silicon Valley Correspondent

Turnstone Systems Inc.’s {TSTN} initial public offering has soared on its opening trading day, trading as high as 90 on Tuesday.

Late Monday, the company priced its 3 million share offering at 29 a share, above its most-recent range of 23 and 25 and a previous range of 15 to 17.


Turnstone Systems post-IPO stock performance

Analysts say the company’s business model gives it a good shot at becoming a critical digital subscriber line (DSL) infrastructure provider.

“Turnstone actually has some major customers and a useful product, which is more than you can say for some other recent IPOs,” adds Kathie Hackler, principal analyst at Dataquest, based in San Jose, Calif. “They should do OK.”

Mountain View, Calif.-based Turnstone sells hardware and software that helps DSL service providers perform remote tests on copper phone lines to determine the ability of individual lines to transport data at high speeds.

The tests can be conducted without having to send service technicians into the field. Turnstone’s software also maintains logs of DSL line and circuit quality that are useful whenever customers move or for a variety of other purposes.

“I think they have some real upside potential,” says Gary Kim, an analyst at NxGen Research, a Chicago-based research firm that tracks the DSL market. “I don’t know of anyone else that is further along in focusing on their part of the market. They’re mining a potentially quite lucrative vein.”

Analysts say Turnstone’s DSL testing products are popular with DSL service providers, particularly competitive local exchange carriers (CLECs), such as Santa Clara, Calif.-based Covad Communications Inc. {COVD}, which competes with regional Bell operating companies (RBOCs), also known as Baby Bells, in a number of markets.

“Simply stated, Turnstone’s system can be the difference between a DSL service provider like Covad making money on an account or not making money on an account,” Kim says.


Covad Communications 52-week stock performance

It often costs a DSL service provider several hundred dollars to add each new DSL subscriber, Kim says, particularly if the service provider must manually test each line. Although available DSL customer retention data are scant, Kim says DSL service providers might only generate between $300 to $400 in income over the life of an individual DSL account if DSL users follow the pattern established by cell-phone customers who, on average, switch providers every two or three years.

“You’re talking about saving a truck roll each time you sign up a new customer,” Hackler says. “It’s all about provisioning each new line as cost effectively as possible.”

At present, CLECs constitute the lion’s share of current Turnstone customers.

“The CLECs have been the most aggressive about rolling out DSL in the business market,” says Mark Zohar, senior analyst at Forrester Research, based in Cambridge, Mass. “The RBOCs don’t want to cannibalize their existing T-1 businesses, and they also have a pretty tight relationship with their existing suppliers.”

One key to Turnstone’s strategy involves using the line quality testing data obtained to help DSL service providers create databases that can be used for a variety of other purposes.

DSL service providers frequently find themselves in disputes with RBOCs, for example, which are required by law to lease certain facilities to the CLECs and to maintain fixed levels of service quality.

“The Turnstone information could be very useful in a courtroom or before regulatory agencies,” Kim says. “CLECs are spending a lot of time in disputes with the local incumbents, so this gives them the evidence and information they need.”

In addition, Kim says a trend toward so-called service level agreements, which guarantee DSL users fixed minimum transmission speeds, can only be honored if DSL service providers know exactly which circuits can handle data at sufficient speeds.

“Internet traffic goes through many different networks,” Kim says. “Service providers need to know the speed each step along the way.”

That need, Kim says, could eventually put Turnstone in a potentially lucrative position as a kind of DSL Internet traffic cop, controlling data from a variety of DSL service providers that, taken together, could be used to more efficiently route traffic over several interlocking DSL networks.

Analysts say prospects of such derivative products and services constitute Turnstone’s strongest suit moving forward. The company’s success over time hinges largely on its ability to use its existing products as a foot-in-the-door that lets the company offer DSL services providers an ever-growing menu of products and services.

“Their software gives them the opportunity to do more as time goes on,” Hackler says.

Competitors in the DSL equipment market include major players such as Harris Corporation, Hekimian Laboratories Inc., Hewlett-Packard Co. {HWP} and Nortel Networks Corp. {NT}, among many others. Another competitor, Lucent Technologies, Inc. {LU}, offers similar but less-powerful DSL test equipment of its own but also has an original equipment manufacturer deal with Turnstone that allows Lucent to sell co-branded Turnstone products.

“Those companies have bigger fish to fry,” Kim says. “I’m not too worried about that kind of competition. Turnstone has a clear focus on the market, while companies like Lucent or Nortel have a lot of other things they need to worry about.”

In addition to Lucent, Turnstone’s current customers include two of the nation’s biggest CLEC DSL service providers, Covad Communications and Rhythms NetConnections Inc., based in Englewood, Colo.

“The fact that Covad, the largest national DSL competitor, has signed up with them for local loop management speaks very well for them,” Zohar says. “It’s certainly a validation of their product.”

Turnstone, which was established in January 1998, posted a loss of $707,000 on revenue of $14.7 million for the nine months ended Sept. 30, as compared with a loss of $2.9 million on zero revenue for the same period a year earlier.

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