Posted 08/2000
The Big Chill
WILL FUNDING FREEZE RESULT IN CONSOLIDATION?
By Ken Branson
With Federal Reserve Chairman Alan Greenspan's moves to increase interest rates and some investors becoming skittish as a result, the rising tide that has lifted high tech has started to ebb. And telecom has not escaped the sea change. Many new, competitive telecom companies that just weeks ago saw the world as their oyster may soon find themselves treading water as sources of funding dry up, say analysts. But consolidation, according to some industry observers, may be a life preserver.
Of course, many high-tech stocks have been hard hit in recent weeks as investors have grown weary of what many consider over-inflated valuations. And the CLEC stocks have been no exception. The Merrill Lynch & Co. Inc. (www.ml.com) CLEC index (33 companies, including those not covered by Merrill Lynch analysts) had lost 13 percent of its value as of June 16--compared to 5 percent for the Nasdaq (www.nasdaq.com), and a flat performance year to date by the Standard & Poor's 500 Index. That has resulted in many companies delaying their IPOs.
Private equity, meanwhile, is getting pickier, analysts say, and not just for early-stage companies. One private equity executive who declined to be named says he and his colleagues are especially leery of companies who have fallen short of expectations, even a little. "There are some companies that have deployed capital, but haven't performed up to expectations," he says. "And they're going to have a difficult time coming back to the well."
The high-yield--also known as "junk bond" equity market also is getting tighter, according to Todd Morgan, vice president of high-yield research at Credit Suisse First Boston (www.csfb.com).
"They want some predictability," Morgan says of high-yield investors. "After a decent run in telecom land for a year or two, a lot of that [availability of high-yield debt] has been given back in the last quarter or two."
Morgan adds that rising interest rates haven't made things any easier, especially for new entrants, because it makes high-yield debt even higher.
"The equity markets are shutting down," says Morgan. "The burst of the Internet bubble, the public CLECs on the Nasdaq getting pulled along, a lot of early-stage folks needing equity and being willing to sell it, and the GST bankruptcy--all that has been a splash of cold water in the face for some folks."
GST Telecommunications Inc. (www.gstcorp.com) filed for bankruptcy under Chapter 11 of the Bankruptcy Act on May 17 (see "Warta's Paper Trail"). The court-supervised auction of its assets was to take place this month. Morgan believes the rapid demise of GST has undermined the view among investors that CLECs, regardless of their debt load, hard luck or missteps, have valuable underlying assets.
On the same day GST filed for bankruptcy, Time Warner Telecom Inc. (www.twtelecom.com) signed a letter of intent to buy all GST's assets for $450 million--less than half the company's capital expenditure for the last two years, and considerably less than half its $1.2 billion debt load. Time Warner Telecom and GST failed to come to a definitive agreement, and GST's assets, at press time, were up for general auction.
With capital markets quickly tightening, consolidation among CLECs, and between CLECs and other service providers, is likely to accelerate, according to Morgan and other analysts. That's because such growth companies have a constant need for capital. If it's not available through an IPO, private equity or junk bonds, one of the only other options is to find a partner with deeper pockets.
"Look at Gabriel Communications Inc. [www.gabrielcom.net] and TriVergent [Communications Inc., www.trivergent.com]," says Ken Hoexter, vice president-broadband research at Merrill Lynch. "TriVergent is one of those companies that was on the verge of doing an IPO and had to pull back, had to take another look at what they were going to do."
According to Morgan, investment bankers may be pivotal players in steering some companies away from the various equity markets and into each other's arms. That seems to be what happened with Gabriel and TriVergent. David Solomon, Gabriel's CEO, claims that it was TriVergent's strong sales force and geographic proximity (covering BellSouth Corp. [www.bellsouth.com] territory, while Gabriel covered SBC Communications Inc. [www.sbc.com] territory) that led him to woo the Columbia, S.C.-based CLEC. However, Charles Houser, TriVergent's CEO, says he had been told by his investment bankers, as he filed his registration statement with the SEC (www.sec.gov), that he shouldn't rush things. "It wasn't like we needed the money in two months or we were going to run out, because we had enough capital to get through the year and into next year," Houser says.
But that might not be good enough.
Table: CLEC LIQUIDITY AND FUNDING SUMMARY
According to Morgan, most CLECs are funded beyond the end of this year, but this leaves many CLECs with shrinking windows of time to secure funding or dramatically reduce cash burn rates. The key for cash-short CLECs is to keep growing, Morgan says, because investors will watch "core growth that solid and consistent execution generates." However, many CLECs, sometime next year, may find themselves caught between a rock and a hard place. As Morgan explains, "They need to continue hyper growth rates in order to attract equity, and they need to husband shrinking cash balances."
Hoexter doesn't see a cash crunch coming, however. He says $11 billion was raised in the sector in the first quarter, and only $15 billion all last year. "When the time is right, the capital markets will fund this market because it is an expanding competitive marketplace," Hoexter says.
Morgan, though he sees a crunch on the horizon, doesn't see any reason to despair. He suggests that most CLECs, aside from merging with or being acquired by other carriers, can rein in their capital expenditures, and possibly delay things like DSL rollouts to husband cash. But consolidation, one way or another, is coming, he insists.
And it's not necessarily going to be Bell companies buying up the CLECs, as had originally been envisioned by many industry watchers. Instead, it could be the CLECs eating the CLECs. And while brand new carriers may see the tightening of capital as a formidable challenge, it could be a boon for others. Some CLECs--McLeodUSA Inc. (www.mcleodusa.com), for example--have a history of acquisition and may discover that this is their lucky day.
"The out-of-region-RBOC-bailing-you-out story is a little tired, and not that likely," Morgan says. "Their ability to do that is somewhat limited. Right now, it's not a clean option."
For an RBOC to buy an early-stage CLEC would be to dilute its earnings per share (EPS), and investors value RBOCs by their EPS. Morgan says that an RBOC, if it were to buy anybody, would have to buy a big company, and there aren't that many left. Companies like McLeodUSA and NEXTLINK Communications Inc. (www.nextlink.com), while they may be big in their own pond, are still guppies next to the RBOCs.
But, whether driven by new economic realities or other factors such as a need to scale, the guppies are getting new teeth through mergers and acquisitions.
Correction
An advertisement on page 99 of the July issue of X-CHANGE incorrectly listed the names of some of the participating companies in The AgENt Conference & Expo. The correct names are ACC Business (www.accbusiness.com), Telemanagement Services Inc. (TSI, www.tsicorp.net) and N.E.T. Inc. (www.netincusa.net).
