Posted: 02/1999
The Road Less Traveled
High-Yield Debt Financing Makes a Comeback--For Some
By Ken Branson
A company that already has plenty of cash--seed money, venture capital, equity investments, etc.--has a chance to secure more through high-yield finance. It also helps if that company already has high-yield debt outstanding.
It was not always so, of course. Investment bankers and financial analysts say that last spring it was possible for many carriers with sound business plans and a strong pulse to get financing through high-yield debt--junk bonds, in Wall Street jargon. But those days are gone, if not forever, then at least for 1999.
Jerry Paul, a vice president at Invesco Funds Group Inc., Denver, says the relatively easy money of last spring was an exception. "There had been a lot of success in the [CLEC] sector for investors, and people were looking for new names," he says. "It was the usual stuff ... greed."
Carolyn Katz, vice president of high-yield securities at Goldman Sachs Inc., New York, thinks both fund managers such as Paul and CLECs themselves felt the need to make hay while the sun shone last spring.
"If you run a fund, you come in to work in the morning, and you either have more money or less money than you had the day before," she says. "If you have money, you need to put it to work. You need to make money for your fund's investors. So, if the yield is there, that's where the money goes." And carriers who discover that high-yield funding is available might try to make use of it earlier than they had planned, knowing that it might not be available when they really need it, Katz says. Indeed, a CLEC might be better off not waiting until it really needs capital before entering the high-yield market.
"If you're looking over your shoulder and see that your competitors may not have capital and you will, that's an incentive [to issue high-yield debt]," Katz says. "You might enter a new market, or buy yourself an ISP (Internet service provider)."
Making a Comeback
The junk-bond market has come back--at least for certain kinds of carriers--because the basic, generic, CLEC business plan is well thought of by investors.
"The appetite and speed of return from the lows of the fall [in the high-yield market] has been a testimony to the viability of the CLEC model," says Dimitri Triantafyllides, vice president of high-yield research at First Union Capital Markets Inc., Charlotte, N.C.
"Everybody knows what happened in the long distance market 12 years ago. These are companies that are worth financing. The Bells will lose market share to somebody, and it will be to some of these better-financed companies."
| "We've really narrowed down what we think the successful players
are, and we aren't interested in going outside those. We've made our bed, big time, for
most of this year." --Jerry Paul, Invesco Funds Group Inc. |
The soundness of the CLEC model led junk-bond investors back into the market by the middle of October, and analysts believe they will be there for most of 1999, according to Trent Spiridellis, telecom analyst at NationsBanc Montgomery Securities LLC, New York.
"The other notable point I would make is that in-flows into high-yield mutual funds have created a supply-demand imbalance that has resulted in tighter spreads and attractive [opportunities] for capital-hungry CLECs to tap the high-yield debt market," Spiridellis says.
The "spreads" Spiridellis refers to are the difference in return between U.S. Treasury bonds and high-yield corporate bonds. The spreads are measured in "basis points," each basis point equaling one hundredth of 1 percent. So, for example, if a company offers a junk bond "300 basis points above Treasury," that means the junk bond offers a return 3 percent higher than a Treasury bond of comparable length. The tighter the spread, the less the difference between Treasury bonds and junk bonds. The less the difference, the better for CLECs.
However, it's better for some than for others, and for many, it's not nearly good enough.
"[The availability of high-yield debt] is pretty much there for the guys who are in good shape," Paul says. "The startup money isn't going to be there."
CLECs who already have high-yield debt outstanding have a better chance of getting more of it, Katz says.
"With new names, there are two problems," Katz says. "First, because it's new, there is uncertainty about pricing. And then, because of what [investors] have recently lived through, they want to see assets, customers, revenues and a management track record."
Jonathan Savas, vice president of high-yield research at Merrill Lynch & Co., New York, says any blemish on that track record can cost money these days.
"A public company that's disappointed [in its earnings results], that [disappointment] is rippled into their bond prices," he says. "You can probably still get it done, but it will be much more expensive than it was 10 months ago. The better-quality CLECs will have to pay 100 to 200 basis points more. The lesser-quality ones--the ones that had poor results in the third quarter--will have to pay ... a few hundred basis points more."
Savas adds that a private company can expect potential investors to examine its sponsors--its venture capitalists, its angels and whatever other equity investors it might have attracted. "Do they know anything about telecommunications?" Savas asks.
After all, junk bonds are called that because they are thought less likely to pay off at maturity than other bonds. Most analysts define junk bonds as bonds rated BBB or less by rating agencies such as Standard & Poor. Junk bond investors are willing to risk a little more to make a lot more money at maturity, but they are not easily seduced. Not anymore, anyway.
Aside from the purely financial aspects of a company's performance, the soundness of its business plan and the intelligence of its sponsors, investors in a CLEC's junk bonds are interested in the company's senior managers. Do these people have a clue? Have they done this before? Have they made money for us before? Analysts say these are the questions in the head of an investor or fund manager as he or she contemplates sinking cash into the operations of a CLEC whose managers have already ingested tens or even hundreds of millions of dollars of other people's money and now propose to swallow his or hers on the promise of a golden egg to be laid in 10 years.
"We've really narrowed down what we think the successful players are, and we aren't interested in going outside those," Paul says. "We've made our bed, big time, for most of this year."
Paul says the quality of a company's management team is all-important to him and his colleagues.
"We bet big on Jim Crowe at MFS (Metropolitan Fiber Systems Inc., now part of MCI WorldCom Inc.) and won," Paul says. "Jim Crowe and his team at Level 3 [Communications Inc., Omaha, Neb.,] are remarkable people. They know they have to balance capital structure and issue equity when they need to. Too many guys get greedy and get into trouble in an unbalanced equity situation."
| "Be EBITDA-positive. That's all the market cares about. They're
tired of CLECs expanding into new markets and pushing EBITDA- positive out another
quarter, another quarter and so on. That's what happened to e.spire." --Jonathan Savas, Merrill Lynch & Co. |
There are two ways for investors in high-yield debt to make money, Paul says. The first is to invest in a company that does its job well and share in its success--"the basic, grind-it-out credit improvement that occurs as business plans are successfully executed." The second way is what Paul calls "the Big Bang Event," in which investors are showered with money, all at once, when their company is bought by a larger company. Like the after-light of stellar explosions, the light from Big-Bang acquisitions is visible in the eyes of CLEC managers and investors long after the actual event. They remember what happened to MFS and Teleport Communications Group Inc., Staten Island, N.Y., which has been acquired by AT&T Corp., Basking Ridge, N.J., and think there is no reason why it shouldn't happen to them.
MetroNet Communications Corp., Toronto, a recent successful entrant in the world of high-yield debt, is a favorite of Paul's this year. On Nov. 5, 1998, MetroNet made a private placement of $225 million in high-yield debt at 10 5/8 percent.
"MetroNet is our favorite," Paul says. "We think it's a no-brainer in terms of management, business strategy and execution. MetroNet is a prime candidate for a Big Bang event."
The fact that not every CLEC can dive into humongous debt is not, by itself, a discouraging thing, analysts say. The basic soundness of the CLEC model, which Triantafyllides says led some investors back to high-yield debt offerings in the fall, apparently holds for other sources of capital as well.
"What has been encouraging is that vendor financing has picked up somewhat, even for companies with high cash losses," says Mark Rose, vice president of high-yield research at CS First Boston Corp. in New York. "Look at Lucent [Technologies Inc.'s, Murray Hill, N.J.] $2 billion deal with WinStar [Communications Inc., New York], which is available to WinStar in $500 million chunks. That was encouraging, because it shows that these companies can get cash."
Rose says that even "tier 2 CLECs"--companies that aren't national players, don't have high-yield financing in place already, operate in small to medium-sized markets or don't have known stars for managers--are generally well-funded through the end of this year.
If the U.S. economy slows down, that could be a bump in the road to more financing, he says. But only a bump. In a slowdown, he says, "companies will travel less, but they'll still have to communicate, and may use telecommunications more."
For the moment, high-yield investors are treating CLECs as "continuing operations," according to Rose. That is, they are following Paul's first route to success. But Rose, too, says that for CLEC managers and high-yield investors, the Big Bang is the ultimate goal.
"What happened to MFS, Brooks and Teleport?" he asks.
They got bought, of course.
"Bingo. They got bought, and bought by very high-quality companies," Rose says.
Stuck in the Middle?
Triantafyllides says that lots of mid-level CLECs with good business plans will find it difficult to get high-yield financing for a while, but he adds that this may not be the end of the world.
"Vendor financing is an alternative, of course," he says. "... If the business plan is executing well, you ought to be able to consider an equity offering. The only reason more companies haven't done that is that they don't want to dilute the stock while the pie is not as big as they want it to be."
So what ought a CLEC do to make itself attractive to investors, besides having a well-thought-of management team, an unblemished performance record and a lot of debt already outstanding?
"If you're a tier 2 CLEC and you're working on the assumption that the high-yield market is just going to be there whenever, and you just go on spending, you're not in a good spot," says Savas of Merrill Lynch. "Be EBITDA (earnings before interest, taxes, depreciation and amortization)-positive. That's all the market cares about. They're tired of CLECs expanding into new markets and pushing EBITA-positive out another quarter, another quarter and so on. That's what happened to e.spire [Communications Inc., Annapolis Junction, Md.]."
Indeed. Originally, e.spire, the former ACSI Communications Inc., told the public it would be EBITDA-positive--that is, have more money coming in than going out before paying interest, taxes, depreciation and amortization--by the middle of 1999. But it's pushed the date back, first to the end of 1999, and most recently to mid-2000, following a series of management changes and the announcement that it no longer would offer local service resale.
e.spire's stock, trading above $23 earlier this year, was in the $7 range by the end of 1998.
Analysts also suggest that CLECs concentrate on getting as many customers "on-net" as possible. Local service resale, one analyst jokes, "is like issuing a press release saying, 'We plan to make no money--ever.'" It may be useful as a market-entry strategy in a city where a CLEC has no facilities, but potential investors like to see the percentage of on-net customers rising steadily. e.spire was thought by some to have lagged in this respect.
Savas says second-tier CLECs ought to consider borrowing money the old-fashioned way--from a commercial bank.
"Some CLECs are at a point where banks would lend to them," Savas says. "They're more mature now. They're a real industry with lots of public companies and lots of data points."
NationsBanc's Spiridellis, however, believes that some tier 2 CLECs ought to stretch a little and go for high-yield financing, even if it is a serious corporate pain. He acknowledges that many mid-sized CLECs are in a "Catch 22," wherein the market will criticize them, whatever they do.
"I know there's a Catch 22," Spiridellis says. "You have to stick to the business plan because if you don't the market won't open up to you. But I personally believe the high-yield market will open up to CLECs that are well-managed, well-capitalized and executing on their business plan, regardless of whether they're first-tier or second-tier. The high-yield investor base is becoming increasingly aware of winning formulas, and to the extent that they see potential success stories, they'll be there to step in and provide financing."
The problem for smaller CLECs, or a first-time player in the junk-bond game, is that nobody knows who they are. The first-tier companies--McLeodUSA Inc., Cedar Rapids, Iowa, or Delta Three Inc., New York, for example--can arrange high-yield debt with a conference call, according to analysts. First-timers literally have to introduce themselves, and that means going on a "road show."
That is, the CEO, chief financial officer and maybe the chief technology officer of a would-be junk-bond issuer literally travel around the country talking to potential investors, analysts and occasionally journalists, telling their story and defending their plan. This is expensive and time-consuming, and that can be difficult for a company that's small enough for its officers to make a day-to-day difference by being in the building. But Spiridellis says there are no shortcuts to doing this the first time out, and it pays off in the long run.
"As they go out on the road and present their plan, if it's sound, it will generate attractive returns on capital," Spiridellis says. "They'll get a lower coupon on their debt. I know it's time-consuming and expensive, but the long-term benefit is that they'll have a lower cost of capital and a higher valuation for the company."
And, eventually, a bigger Bang.
