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Hanging up on CLECs
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April 10, 2001: 2:38 p.m. ET
Investors, fearing debt load, don't want to connect with local exchange carriers
By Lisa Meyer
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SAN FRANCISCO (www.redherring.com) - Debt matters.
A good number of competitive local exchange carriers (CLECs) had to rediscover this age-old business adage the hard way. And so did their investors. Indeed, the more debt a company has, the more concerned an investor should be -- especially in today's market, where capital funding has dried up.
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If a company can't pay off its debt, its financials are a constant drain on cash that could be used to build its business
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Adam Giansiracusa
Frost Securities analyst |
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As it turns out, too many CLECs had grander plans than they were able to fund. Once Wall Street's darlings, the alternative telecom sector is now struggling. Many of them, including e.spire Communications and ICG Communications, have filed for bankruptcy. And even more are on the brink.
Lacking money to continue building the networks that will attract customers, many CLECs are fighting to generate enough cash to pay off debt. In order to achieve a sustainable profit in the telecommunications industry, a company has to own substantial network assets like fiber-optic lines and switches. Acquiring such assets, though, is expensive. CLECs can rent network capacity from dominant local phone companies. But such leases cut into profitability.
So, like most telecom challengers, CLECs have been at a disadvantage from the outset.
"If a company can't pay off its debt, its financials are a constant drain on cash that could be used to build its business," says Adam Giansiracusa, an analyst at Frost Securities. "A difficult capital market undermines a fragile business model."
And once investors noticed that little chance existed for some CLECs to raise the money they would need to continue expanding, an avalanche of selling began.
On the brink
Both Winstar (WCII: up $0.03 to $0.37, Research, Estimates) and Teligent (TGNT: up $0.02 to $0.42, Research, Estimates) are now penny stocks. Winstar closed on Monday at 34 cents, off its 52-week high of $54.13, while Teligent finished at 40 cents, down from a peak of $55.50. In essence, both have lost 99 percent of their value.
Last week, Winstar announced two efforts to cut costs. The company said it would lay off 2,000 employees, or 37 percent of it work force, and halt its aggressive network buildout, cutting its expected capital expenditures for 2001 to $200 million from $700 million. Winstar said that it would focus on penetration of its existing broadband fixed-wireless network, which includes services in approximately 150,000 businesses in 5,400 buildings as of March 31. Winstar did report a 59 percent year-over-year revenue increase during the fourth quarter, and $291 million cash on hand, but most analysts agree that won't carry the company for long. Winstar also reported $3.64 billion in long-term debt as of December 31, 2000.
"The industry has a few more shoes to drop," says Ryon Acey, an analyst at BB&T Capital Markets.
Most likely, the next will be Teligent, which transmits voice and data services through the air rather than over fiber or copper networks. In its year-end report filed with the Securities and Exchange Commission, the company reported that it lacks the funds to operate its business through 2001.
Sweet spots
But this is not to say that all alternative telecom companies are doomed. A few bad apples haven't spoiled the whole bunch. Indeed, once the market tosses the rotten CLECs out, the healthy should reap the benefits of a less competitive field. Surviving CLECs might experience less financial pressure because any existing capital will flow more efficiently to a select group.
Essentially, the wheat is beginning to separate from the chaff. In a recent study, The Strategis Group estimates CLEC industry revenue will grow by 357 percent over the next five years. "Diminished access to capital and increased pressure to demonstrate strong operating results, combined with the necessity to achieve economies of scale and scope, will inevitably lead to consolidation in the CLEC industry," states Peter Jarich, director of broadband research at the consultancy. "Primarily because of the failures and the bankruptcies, the CLEC industry will ultimately be comprised of a much smaller group of larger and stronger companies better able to compete against the ILECs [incumbent local exchange carriers] and each other."
But not all companies that are sinking will be buoyed by an acquisition. As AT&T's (T: up $1.22 to $22.02, Research, Estimates) recent purchase of the defunct digital subscriber line (DSL) company NorthPoint Communications's assets demonstrated, many established phone companies might just wait for the CLECs to go under before buying their valuable parts for bargain prices.
Whether a dying CLEC will be acquired before it files for bankruptcy depends on the quality of its revenue, says Mr. Acey. A revenue stream coming directly from an end user, for example, is more valuable than one that comes from another carrier. "When you sell to another carrier, you are largely a one-trick pony, offering a limited number of products," Mr. Acey explains. "When you sell to an end user, you have an opportunity to sell a full bundle of services, be a one-stop shop. What differentiates the winners and losers going forward will be the quality of the customer."
Too much debt for XO
In an effort to separate themselves from struggling rivals Time Warner Telecom (TWTC: up $6.45 to $40.90, Research, Estimates) and XO (XO: Research, Estimates) (Estimates) recently issued statements that they have the money to continue expanding. Time Warner Telecom reaffirmed its original 2001 guidance by saying its current business plan is fully funded with its cash on hand, available credit lines, and positive earnings before interest, taxes, depreciation, and amortization (EBITDA). Last week, XO reiterated that it continues to maintain a strong financial position with an ability to fund its operations into the first half of 2002. Time Warner Telecom's revenue increased 81 percent to $487.3 million in 2000, and XO's sales grew 164 percent last year to $723.8 million.
But both companies are expected to widen their losses sequentially in the first quarter and for the year. Time Warner Telecom recorded a 3 cent loss per share in the fourth quarter of 2000, and according to First Call analysts, a loss of 28 cents per share is expected in the first quarter. The company earned 1 cent per share for the full year 2000, and analysts are predicting a loss of $1.33 per share in 2001. XO posted a loss of $1.29 per share in the fourth quarter of 2000 and is expected to lose $1.35 per share in the first quarter. Last year the company lost $4.24 per share, and this year analysts expect it to lose $5.51 a share.
As of December 31, 2000, Time Warner Telecom had only $585 million in long-term debt, while XO had $4.4 billion. Long-term debt accounts for 50 percent of XO's capital, while Time Warner Telecom's debt-to-capital ratio is 55 percent.
But while XO may be close to a penny stock, finishing Monday at $3.52, or 94 percent off its 52-week high of $55.38, Time Warner Telecom is currently trading at $34.45, or 56 percent off its 52-week high of $78.13. It obviously helps that AOL Time Warner (AOL: up $0.58 to $40.05, Research, Estimates), the parent company of CNNfn, owns 48 percent of Time Warner Telecom.
Pledging allegiance
McLeodUSA (MCLD: up $0.82 to $8.88, Research, Estimates) joined recent efforts to reassure investors by reconfirming financial guidance for 2001. The company reiterated that revenue should increase 50 percent year-over-year to $2.1 billion and that EBITDA would increase 270 percent to $225 million. McLeodUSA has been successful in keeping down marketing costs and winning new business by convincing voice services customers to buy into the company's data service offering, says Dan Ross, an analyst at Sanders Morris Harris.
But the company's stock is currently trading at $8.06, or 71 percent off its 52-week high of $27.75. McLeodUSA had $2.7 billion in long-term debt at the end of the fourth quarter, but its debt-to-capital ratio of 42 percent is lower than Time Warner Telecom and XO.
Finally, with the lowest amount of long-term debt of the lot Allegiance Telecom (ALGX: up $1.56 to $14.31, Research, Estimates) had only $566 million in long-term debt at the end of 2000. Allegiance's strategy is to own the switches that guide customer traffic and lease the capacity from established phone carriers.
Such a tactic has paid off. The company's debt-to-capital ratio, at 35 percent, is also the lowest of the major CLECs. And revenue in the fourth quarter increased 142 percent year-over-year to $95 million.
"At the end of the day, Allegiance is executing," says Mr. Ross. "It is delivering on their promises to customers."
But investors will have to pay a slight premium for Allegiance's stock. It is currently trading at three times estimated 2001 revenue of $550 million, compared with McLeodUSA's multiple of 2.3 times estimated 2001 revenue of $2.1 billion and XO's price-to-sales ratio of .9 times 2001 revenue estimates of $1.4 billion. Time Warner Telecom is the most expensive of the bunch, trading at five times 2001 estimated revenue of $751 million. Still, our favorites are Allegiance and McLeod, since they aren't as debt-laden as the rest of the group. 
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