Vital Statistics

Posted: 08/1999

Vital Statistics
Evaluating the Health of the CLEC Business
By Deborah Strong and John Ahsler

Competitve local exchange carrier (CLEC) stocks have sprinted ahead this year with strong performance forecasted through the remainder of 1999. Increasing demand for bandwidth, continued market pressure for alternative choice and continued penetration of the Internet and Internet-based applications have been the primary drivers of CLEC success. However, not all CLECs have had equal success. While companies such as Allegiance Telecom Inc., Dallas; NEXTLINK Communications Inc., Bellevue, Wash.; and Qwest Communications International Inc., Denver, have seen their valuations soar, other companies, including FiberNet Telecom Group Inc., New York; MGC Communications Inc., Las Vegas; and USN Communications Inc., Chicago, have experienced tremendous losses.

The carte blanche access to capital that was evident in the marketplace through mid-1998 is gone, and even as capital has flowed back into the sector, investors are taking a closer look at CLECs' ability to deliver on expectations.

Volatility in the CLEC marketplace, with up to 35 percent market swings during a given quarter, reflects how difficult it is to accurately and quantifiably measure the value of these companies. The market typically evaluates companies based on standard financial measures, including price/earnings multiples. CLECs as a group defy the standard measurements, with high capital expenditure (CapEx) and significant losses in early years. However, as companies, including ICG Communications Inc., Englewood, Colo.; Intermedia Communications Inc., Tampa, Fla.; and McLeodUSA Inc., Cedar Rapids, Iowa, reach maturity and turn the corner to show earnings before interest, taxes, depreciation and amortization (EBITDA), positive valuation measurements change (see "CLEC Vital Statistics" chart, below). Revenue growth expectations have reached their peak, with new emphasis being placed on gross margin. Valuation multiples based on property, plant and equipment (PP&E) and revenue have declined to reflect the shift away from growth for growth's sake to margin, profits and operations.

So CLECs should be evaluated on four categories: financial, organizational, market and operational performance.

Financial performance focuses on CLECs' revenues, debt, liquidity and cash burn associated with losses and capital expenditure. In the past, the investment community has viewed CLECs as having unique credit risk and equity valuations assigned by mergers and acquisitions. Investing in CLECs has become increasingly complex and it has become clear that not all CLECs are going to be acquired in the near term. Moreover, CLECs are entering multiple lines of business such as Internet access, web hosting, long distance and private data networking. The evolution of CLECs into integrated communications providers (ICPs) is well under way and this has created new challenges for investors. The financial community has begun to sort out more robust measures. Key financial areas include quality of funding (equity capital, anchor tenants, construction contracts, early adopter accounts); use of funds (capital emphasis [transport, switches, market expansion, product expansion, maintenance] and expense [salaries/rent, sales/marketing, operations support systems (OSSs); financial ratios (debt capitalization, EBITDA/revenue, SG&A/sales, PPE/debt); and financial milestones (revenue/cash burn, EBITDA break-even, 1x interest coverage and free cash flow).

Organizational performance focuses on quality of the organizational structure and productivity of employees. Key organizational areas include: quality of management team (corporate leaders, board members, affiliations, partnerships); dependency on contractors; employee turnover and ability to fill vacancies; and number of employees and sales force productivity.

Market performance focuses on types of markets served, product set offered and success within those markets and product sets.

Key market areas include markets served (tier 1, 2 and 3); product mix (dedicated access, switched access, long distance, Internet service, virtual connections, electronic commerce, asynchronous transfer mode [ATM]); network mix (unbundled network element [UNE], T1, resale, own vs. lease); and market share (number of lines, churn, excess capacity).

The products a CLEC chooses to provide and the network approach of providing these products impact CLECs' margin potential and available market, and drive the level of OSS required (see "Options Affecting OSS Requirements" chart, page 59).

What the market has realized is that CLEC growth is limited by the ability of the company to execute, e.g., to leverage network assets and profitably grow the business. "Lessons from MFS and TCG acquisitions is that the major operators aren't interested unless you are EBITDA positive, which means you need to focus on margins," says Brian Lessard, an investment analyst with Aetna Inc., Hartford, Conn. "The ability to execute is directly tied to back-office and OSS issues. Scalability to support market expansion and mergers and acquisition activity is of particular concern."

Until recently, OSS architecture was rarely discussed openly and communicated with the financial community. CEOs and investors now are interested in the CLECs' ability to bring in the necessary systems to enable scalability and reduce operating costs. Two questions that now are being raised include: what is the impact of the OSS investment, in terms of both time and money?; and how far along are you in your OSS deployment?

OSS and systems architecture has had an impact on valuations. "Intermedia, with the earning surprises caused by lack of post-merger system integration and consolidation, demonstrates what can happen if you don't focus enough on OSS," says Lessard, "and on the flip side, e.spire Communications [Inc., Annapolis Junction, Md.], showed us how you can go too far with OSS investments, with their valuation still hurt by the massive spending in OSS that Pompliano corrected." Waldorf adds, "e.spire was deploying a back office that was clearly too expensive in too short a timeframe to maintain profitability." By comparison, he continues, Electric Lightwave Inc. (ELI), Vancouver, Wash., has made sound investments in OSS infrastructure steadily over the past few years with payoffs starting to be realized later this year.

The performance standards against which CLECs will be held are changing constantly. However, it is safe to say that over time the strategic asset value and latest technology deployments will not be sufficient to attract additional investment or increase value. Investors will always need to consider the ability of a firm to take advantage of the increased demand for alternative service providers and industry consolidation, as well as the residual value of assets and franchises. Risk/return evaluations always must include assessments of competitive, regulatory and technological risk dynamics. However, these measures alone do not complete the picture of CLEC value. Investors want to know more and want to monitor CLECs on an operational basis. With financial success heavily dependent on OSSs, investors need to get a sense of the status, progress and plans in the OSS area as well as within the network.

Traditionally, CLECs have been more preoccupied with network deployment and market growth than with the development of a disciplined approach to measuring performance in key business areas. The network is only one potential source of operating leverage for carriers. The investment community has an appetite for more information beyond network statistics. As the CLEC industry matures, it must support a new and more balanced approach to performance comparison and valuation. Retooled CLEC performance measurement is important from two perspectives. From an internal perspective, CLECs need to gauge performance to measure success, prioritize areas for improvement and allocate precious capital. From an external perspective, CLECs need to communicate their value and strategic advantages to the investment community to realize full value.

Emphasis on performance measurement and tracking also is becoming more important within the CLEC community. Evaluating performance in a rapid-growth environment requires a flexible but disciplined model.

On-net always is better, and the profit margin potential for on-net products are obvious. Tier 1 market presence has helped the valuations of NEXTLINK and WinStar Communications Inc., New York. However, one must balance being just another competitor in a tier 1 with dominating a tier 2 or 3 market.

Operational performance focuses on the ability of the operation to meet commitments, to deliver quality, and to grow with sales.

Key operational areas include: level of automation (flow-through provisioning); network quality (availability, repair metrics, latency); service quality (ability to meet commitments, competitiveness of cycle times, repeat problems); scalability (OSS quality, dependency on manual processes); and differentiation (use of the web for customer relationship management, for example).

These operational measurements demonstrate the true ability of the CLEC to scale, but present some frustration for the investment community as these metrics are not readily available. However, whether or not a CLEC chooses to share these types of performance metrics is not as important as the CLEC using these measurements internally to optimize the operations to achieve profitable growth.

Comparing CLECs along metrics is difficult. Some CLECs have a "fiber and switch model," such as ELI, e.spire, GST, ICG, Intermedia, McLeod, NEXTLINK and Time Warner Telecom Inc., New York. Others have a "smart build model," with switches but no fiber, such as Allegiance; US LEC Corp., Charlotte, N.C.; and Focal Communications Corp., Chicago. Digital subscriber line (DSL)-oriented CLECs present another category, including Covad and Northpoint. However, even CLECs within the same group can be at different stages and cannot be compared directly. For example, McLeod, Time Warner Telecom and ICG are clearly at different growth stages than e.spire and ELI.

At each stage of development, CLECs face different operational and business challenges. CLECs tend to evolve through a five-stage model: ground zero (obtained major sponsorship, "anchor" tenants, key accounts, ramping up); high-yield financing and/or initial public offering (IPO) to support network deployment; rapid growth (extensive market and product expansion break-even status); EBITDA positive, continued growth in markets and products; and going concern (self-funding, focused on maintenance and retention).

During the earlier stages, more emphasis should be placed on corporate sponsorship and network deployment. During growth stages, metrics that reflect the ability to scale and service customers become more important. During maintenance stages, retention and service quality should be emphasized. These stages and objectives are similar to those cellular and long distance companies went through in the 1980s.

Clearly, performance metrics are critical in gauging and optimizing business performance from an internal perspective. Use of nontraditional measurements, including OSS back-office and operational metrics, are required by the investment community in evaluating CLEC performance as emphasis is placed on profitable growth and scalability. CLECs should implement a balanced approach to assessing and communicating the health of their enterprise.

Deborah Strong is a principal with BusinessEdge Solutions Inc., Edison, N.Y., which works with CLECs to plan and implement service differentiation strategies, including OSS architecture and integration and business process optimization, and CLEC Balanced Scorecard programs. She can be reached at dstrong@businessedge.com or 203-618-0705. John Ahsler is an analyst for the High Yield Division of Wasserstein Perella, which works in the CLEC market to assess the quality of debt for the investment community. He can be reached at john_ahsler@wasserella.com or 212-969-2615.