Posted 03/2001
Business and Finance
Temperamental Journey
Potential Recession Both Good and Bad for CLEC Market
By Becky Bracken
The bad news: The prospect of a possible nationwide economic recession adds to the pressure CLECs are already feeling, threatening to finally kill some of them off for good.
The good news: A national recession may not hurt the CLEC sector as much as other industries and even incumbent carriers. What is more critical, according to experts and analysts, is a rebound of the debt, capital and high-yield markets that could free up funding for cash-strapped competitors.
Regardless of the overall economy's temperament, CLECs must slow their cash-burn and stockpile cash reserves until investors feel more confident about their ability to see returns on their business models.
No matter what happens with the economy, businesses and residential consumers alike are going to have a need for telecommunications. While budgets for telco spending may shrink, there will still be demand for services. A likely scenario would be for CLECs to even pick up added market share because of their competitive pricing structures. As money gets tight for consumers, price is going to become an increasingly important factor in communications purchase decisions.
James Henry, a CLEC analyst for Bear Stearns & Co. Inc. (www.bear.com), agrees that CLECs would be in a prime position to take market share from incumbents in the event of an economic slowdown, based upon their low-cost pricing. He adds that there are wide economic indicators that prove that telecommunications growth is much stronger than the overall national economy. He says that telecom industry growth has outpaced Gross Domestic Product (GDP) growth by up to a factor of two, indicating that even in a shrinking economy there is room for CLECs to expand.
Tech Efficiencies for Biz
Also significant to note is that with technological advances in telecommunications, business dealings can easily be carried out over fiber, a cheap alternative to airfare and other types of travel for enterprises, perhaps increasing market opportunity even further for CLECs.
"Low cost and greater utility in a flagging economy --that's probably a pretty good thing," Henry says. "When the economy slows, it's not good for anyone. But it's particularly bad if your business growth is subject to the industry as a whole. What's great about the CLECs is that they're predicated on taking share from the existing market. It doesn't matter if the entire market grows."
The regional Bells need the entire industry to grow 5 percent annually in order to keep their top-line growth going. For CLECs, though, if industry growth was flat, they could still grow at double-digit rates because they're taking market share within the industry, Henry adds.
But while the threat of an overall U.S. recession doesn't seem to be a leading fear of industry insiders, some would argue that the tight capital markets have already sunk the entire telecommunications sector into a large-scale recession of its own.
"A broad economic recession in and of itself doesn't have much of an adverse effect on a business like telecommunications that has such huge growth inherent in it, because it's an increasingly big opportunity," says Steve Meredith, a partner and VC attorney with Edwards & Angell LLP (www.ealaw.com) , a law firm involved in major venture capital investment deals in the telecommunications sector. "I won't call it completely immune to recession. But if you define recession as being telecommunications companies in the doldrums, I think we're right in the middle of about as bad as it gets. And that is not so much a function of overall U.S. economy issues as it is an incredible credit crunch that has hit the telecommunications sector. The telecom sector in general has been overly punished for poor performance by some selected companies."
Cash-hungry CLECs have been shut out of capital markets and many already have, or will shortly, run out of money. Layoffs, restructuring and bankruptcies undeniably litter the headlines.
"If you do have a recession, that's obviously going to put pressure on the CLECs' ability to access the capital markets, and clearly there's already an extraordinary amount of pressure there," Henry says. "CLECS have effectively been shut off with the exception of just a handful of names like XO Communications (www.xo.com) and McLeodUSA Inc. (www.mcleodusa.com)."
Even the most well conceived business plans have fallen victim to being lumped into the same category as failing, over-ambitious CLECs. IPOs for telecommunications companies have halted and banks are reluctant to part with cash. This has left CLEC management teams with only the venture capital markets as a source of life-giving dollars, a generally bad proposition for any investor.
"Once the high-yield [market] shuts down and your bank lenders shut down, the only way you can fund the difference is with more equity dollars," Meredith says. "And once a venture capitalist finds out they have to put in two or three or four times the money into this well- conceived project than they originally thought, the returns that they are going to get at the end of the day are much lower. That's really what I think we're in the middle of right now."
CLECs face more stringent requirements for capital than ever. According to both Meredith and Lee Slap, also a VC attorney and partner with Edwards & Angell L.L.P., CLECs need to clearly demonstrate the viability of not only a business plan, but also the ability to stick it out through tough times.
The single biggest factor in determining economic viability of a CLEC, according to Slap and Meredith--the legal architects for several telecommunications venture capital deals--is, and will continue to be, the quality and experience of management teams.
Slap cites the recent $175-million financing package procured by Virginia-based Cavalier Telephone (www.cavtel.com) and its president, Brad Evans. His track record allowed his company to secure financing at a time when other companies were getting the cold shoulder from investors.
 |
| Steve Meredith Edwards & Angell LLP |
"Before [Evans] started Cavalier, he built Phone Michigan and raised a lot of equity and bank debt in that process, and successfully sold that company to another company, which was then subsequently sold to McLeod," Slap says. "Brad has an excellent track record, and so there were a lot of people both at the bank level and the private equity level that were very interested in backing Brad Evans."
Indiscriminate Funding
Cavalier and Brad Evans are representative of what is happening in the VC markets right now. Slap says that much of the cash that was indiscriminately being thrown at telecom service providers a year ago came from general funds not specifically focused on the communications sector. When these investors were burned, they pulled out of telecom practically altogether. What cash that remains available comes from telecom-specific funds that are more astute and experienced at identifying long-term winning business models.
"About a year ago, some large LBO (leveraged buyout) players came in at very high pre-money values and put a lot of money in these companies, in the hope and expectation that these companies were going to turn around and go public very quickly," Slap says. "Then March and April happened, and the IPO market shut down. I think the IPO market is fairly non-existent at the moment for telecom companies. You're going to see those LBO funds that were more than happy to lay out big bets on these companies going away. So now these companies are back looking for new equity investments, and the valuations are significantly below what the LBO shops had invested at, and they're just feeling very burned right now. Once the IPO market comes back even just a little bit, people will feel more comfortable about their ability to realize a return on their investments and exit out of them, and that will get funds flowing more as well."
CLEC management teams can take heart in knowing that investors have money to spend. Investors are out there looking for opportunities, but they are moving cautiously, to say the least.
"There are a lot of private equity finds that have, in the third or fourth quarter of 2000, raised a new fund, and they have to deploy that capital in some way," Slap says. "So the clients of Edwards & Angell, such as MC Venture Partners (www.mcventurepartners.com), Providence Equity Partners Inc.(www.provequity.com), and Spectrum Equity Investors (www.spectrumequity.com) to name a few, have a lot of capital to deploy, and they are focused on the telco space and related industries. So I think you will see investors such as these continue to look for opportunities, and continue to invest in what they perceive as good opportunities."
But convincing seasoned telecommunications investors won't be easy. "Good opportunities" for investors require increasingly solid business acumen.
"The other factors you will see that will attract capital are: high penetration rates in the focus markets that a CLEC is competing in, continued growth in subscriber lines, low churn," Slap says. "A company that will be at or near cash flow positive will be more attractive than one that needs a significant amount of capital to fund out the rest of the business plan. And you shouldn't lose sight of billing and OSSs; those are critical as well. It's all of those factors. It's the ability to sustain that growth going forward."
A year ago, Slap and Meredith agree, there was a big over-valuation of the pure DSL providers and a lot of investors got burned by betting on the "wrong horse, if you will," Slap says. "But I think going forward, what you're going to see is that companies that are focused on building out a relatively small number of markets, and are focused on penetrating those markets, and who have or are developing infrastructure independent of the RBOCs [will] continue to attract capital."
Independent Operator
A widespread recession may make it more necessary than ever to operate independent of RBOCs, according to Henry.
"Maybe the incumbents are seeing slower growth and are going to be less cooperative to the CLECs if they're taking share," Henry says.
So investors will be looking more closely than ever for business models independent of the incumbent networks.
"There are clients that have recently refocused their business plans," Slap says. "Focusing on a smaller number of core markets, they have recently laid off a fair number of people and they are preserving cash. Their venture backers have told them that their current rate of burning through cash is not sustainable for the long run, and they need to focus on the essential elements--the blocking and tackling, if you will, of building a strong company. Getting closer to cash-flow even, because that's what is going to get them to the next round of financing."
 |
| Lee Slap |
When that next round of financing may come seems dependent on a number of market factors.
"If you get the debt market back and the public equity back, that's going to help a lot," Slap says. "But in the short run, it's probably just the truly telecom-focused earlier stage investors that are going to stay in the market. I think they'll reap very large rewards because they'll be able to invest at very reasonable valuations, and they'll prosper accordingly."
While investors wait out unfavorable market conditions, many of them are turning to European CLEC counterparts.
"A lot of them are looking more and more at investing in European equivalents of CLECS," Meredith says. "Partly that is because the capital markets in Europe debt-wise are a little less unfriendly. This is about as bad as it gets. So a lot of them are looking toward Europe."
Another aspect of the capital market is the equipment manufacturers that continue to be pummeled by the market. CLECs were able to get equity from manufacturers in the form of equipment.
"But the Lucents of the world have really taken it on the chin in that they have been essentially funding people through the purchase of their own equipment," Slap says. "And a lot of that debt is under water at the moment, and Lucent's performance is reflective of that. Once you get the high-yield market back, the banks come back and, hopefully, the equipment manufacturers recover and then are willing to make some leverage available. Then you will see, I think, a lot more investment activity in the CLEC market."
Those are certainly a lot of "ifs" and "whens." And while a widespread economic slowdown may not directly affect CLEC operations and market share, these markets are going to need to revive, a prospect that is increasingly more difficult in tough economic times.
"Do [CLECs] have enough capital to survive until the capital markets open up a little more?" Slap asks. "I guess I would agree with the proposition that a sustained U.S. recession would be detrimental to even some of the good, solid companies."
So, the name of the game until further notice is cash conservation. Simply staying alive through the tough times will go a long way to ensuring ultimate victory.
"Only time will tell who will be able to sustain a capital market," Slap says. "Can they survive until those markets come back? The very good of the good will, and the weaker will not survive, but that creates another opportunity for investment in the market. For instance, a company like Cavalier that has a fully funded plan now, will have weaker competitors in that market. A recession will have the good effect of making businesses focused on building true value in a traditional sense, and not attempting to do it all and do it all very quickly," he adds.
So, while talk of a looming recession may not initially strike fear into the hearts of well established, fully funded CLEC players, others wait and hope for the markets to rebound.
Every indication from analysts is that it's going to get worse before it gets better. There is money to be spent, but in the wake of the dot-com collapse, investors aren't interested in investing in technologies. Instead, they want solid business acumen, reasonable growth expectations and deep penetration.
"Entrepreneurs in this space need a reality check as to what's happened to the valuations of their company," Slap says. "They have some very lofty expectations that just aren't going to be met in this market."
