On the Auction Block

Posted 05/01/2001

On the Auction Block
BOCs, IXCs Among Likely Bidders for DSL Assets

By George Adcock and Gail Lawyer

With financial woes besetting the DSL industry, it was just a matter of time before the assets of data LECs would be put on the market at fire-sale prices and be scooped up by those with deeper pockets.

Among the potential buyers are Bell companies that were pushed aggressively into the DSL business by the upstarts, which now find themselves in dire financial straits. These include ISPs and IXCs that could look to diversify their access technologies and compete against telcos and cable companies in the local market.

First on the auction block was NorthPoint Communications Group Inc.'s (www.northpoint.net) property. NorthPoint filed for bankruptcy in January. In late March, the U.S. Bankruptcy Court approved the sale of substantially all of NorthPoint's assets to AT&T Corp. (www.att.com) for $135 million.

That's a far cry less than what most analysts had expected the assets would fetch. Prior to the sale's approval, Bear, Stearns & Co. Inc. (www.bearstearns.com) analyst David Fore predicted that NorthPoint's assets, which were estimated to be worth about $526.6 million, would be sold for about 70 percent of their value. That would be in the neighborhood of $368.6 million. In actuality, NorthPoint's assets went for less than half of that.

What AT&T got for its $135 million was NorthPoint's nationwide collocation arrangements, certain network equipment, systems and support software. The net purchase price is being applied in its entirety to satisfy part of the outstanding claims of NorthPoint's senior, secured creditors.

AT&T didn't get all of NorthPoint's assets, however. The company still has certain tangible and intangible network, office and related assets, customer contracts and the pending claims against Verizon Communications Inc. (www.verizon.com) for termination of the NorthPoint-Verizon merger agreement last year. These remaining assets will be liquidated to raise cash.

NorthPoint's equipment, software and customer base aren't the only available assets from the fallout in the DSL industry. Companies, such as Jato Communications Corp. (www.jato.net), simply shut their doors and went out of business. Others, like HarvardNet (www.harvardnet.com), decided to get out of the DSL business and concentrate mainly on web hosting.

In many instances, the exit from the business by these companies left a large customer base without DSL service and a lot of unused equipment sitting around.

It's likely we will see a slow but continuous absorption of remaining assets, as other carriers and perhaps some ISPs know of the vastly-reduced prices for these assets.

This did not surprise many industry watchers.

"The original idea was for the DSL companies to build a network, then have it bought," says Robert Rosenberg, president of The Insight Research Corp. (www.insight-corp.com). "It's always been the theory that an IXC would be in the market. Maybe they held off when they saw the companies flounder. There was incentive to let them flounder and buy assets wholesale."

Rosenberg thinks the IXCs are the most likely candidates to pull in the remaining assets, but he notes the BOCs cannot be ruled out, especially since SBC Communications Inc. (www.sbc.com) bought about six percent of Covad Communications Co. (www.covad.com).

"Verizon is the most likely to buy some assets, and Qwest [Communications International Inc., www.qwest.com], BellSouth [Corp., www.bellsouth.com] and, of course, SBC can't be ruled out," Rosenberg says.

SBC acknowledges that it is open to the opportunity for scooping up some of these assets.

"We never rule out any opportunity," says SBC spokesman David Belgrade.

He adds that SBC is happy with its current assets, and is not actively looking for buys, now that it has made the Covad connection. But the door remains open.

"We are exploring ways to leverage the opportunity with Covad, and continue to look at other opportunities to partner with DSL providers," Belgrade says.

SBC is arguably the most aggressive BOC in deploying DSL. It ended 2000 with 760,000 subscribers, and it had deployed DSL capability to 50 percent of its addressable market. It plans to end this year with virtually its entire market covered through what it terms "neighborhood gateways."

"What we have done is taken our central offices to the neighborhoods," Belgrade explains. "When we are fully deployed, 60 percent of the network will be within 6,000 feet of a gateway."

This deployment is contrary to the historical foot-dragging the BOCs have exhibited in the past. They have been so slow to move into the DSL space, many observers have feared that if only a few DSL providers exist, there would be no pressure on the BOCs to deploy.

Judith Hellerstein, president of Hellerstein and Associates (www.jhellerstein.com), a telecom consulting firm, opines that the BOCs have been less than ecstatic about deploying DSL.

"BOCs might continue to drag their feet without competition, but there is a lot of demand for DSL now, and that might change," she notes.

In fact, it clearly is changing. Besides SBC, BellSouth has mounted a massive deployment strategy that will see 600,000 DSL subscribers by the end of this year.

BellSouth got a later start than its southwestern cousin, ending 2000 with 215,000 subscribers. Director of marketing and product development for wholesale DSL services Eric Fogle says that it wasn't foot dragging.

"We had moved to fiber over a large portion of our network, and that takes different equipment and more time to deploy," he explains.

Now the company aggressively is deploying remote terminals, and will take its DSL coverage from 45 percent of its customer base to 70 percent this year, Fogle says.

Many analysts, such as Rosenberg, like to suggest that BellSouth may be a probable buyer of some available assets. Fogle insists that is not in the cards, however.

"Everything we do in DSL will be BellSouth--BellSouth equipment and BellSouth facilities. We won't be looking to buy anybody else's assets," Fogle says.

BellSouth's rumored--but so far vehemently denied--desire to merge with Sprint Corp. (www.sprint.com) could have something to do with that view. Certainly, a BellSouth/Sprint combination may change everything.

Even if some of the BOCs decline to get into the asset absorption game, other potential buyers exist. For instance, Hellerstein says ISPs shouldn't be overlooked.

"The ISPs may face some difficulty buying central offices since they're not telecom firms, but they are definitely potential buyers," she says.

She cites Telocity Inc. (www.telocity.com) and EarthLink Network Inc. (www.earthlink.com) as the most likely companies to surprise everyone with a move into the DSL space.

The director of broadband analysis at New Paradigm Resources Group Inc. (www.nprg.com), Greg Mycio, raises an eyebrow at the EarthLink mention.

"I wonder how Covad would feel about that?" he asks, noting that Covad provides EarthLink with many of its DSL connections.

Maybe Mycio shouldn't be surpri- sed. John Ellis, director of broadband products for EarthLink, doesn't find the proposal surprising.

"We never turn down an opportunity when we see it," Ellis says.

While Ellis will not say that EarthLink definitely will buy abandoned DSL assets, he says the company is not above doing so. And with EarthLink's energetic expansion of its DSL offerings, the notion does not at all seem far-fetched.

The ISP even is introducing satellite connections this year. This will give EarthLink an initial peripheral foray into its own network.

Then there is Covad. The DLEC continues to be the litmus paper that analysts use to test the DSL space. At least half of those analysts believe the company will be sold to an IXC or ILEC. They see it as the most viable of DSL companies, and therefore a perfect buy for a large, well-funded telecom firm.

But Covad chairman of the board Chuck McMinn has only one thing to say to them: "We are NOT for sale."

He acknowledges the recent problems Covad has faced--a one-day delisting from the Nasdaq, the drying up of funding, lowering of revenue projections by $200 million, and all the other body slams that have put so many competitors on the mat.

But McMinn insists Covad has gotten off the mat, and it is circling its opponent. Indeed, a recent move would seem to underscore that: Covad signed a deal with MegaPath Networks Inc. (www.megapath. net), a former Northpoint ISP customer, to provide the lines no longer available from the failed DLEC.

Moves like this prompt McMinn to insist that Covad can and will achieve what he says the financial markets now demand--profitability.

"We can become profitable because we did build out a huge network; we can't cut to profit," he emphasizes. "We have to load [it] to profit."

Before the difficulties, Covad's goal was for maximum growth and subscribers, he says. Now it is to get to profit as quickly as possible.

"Part of that strategy is not to grow anymore," which includes cutting back on the least profitable customers. Other steps include:

• raising prices;

• giving most of the marketing chores to their ISP partners;

• shutting down one of three operating centers (Atlanta); and

• changing its private label (LaserLink) to Covad Internet Services.

McMinn says these and other steps have lowered the company's EBITDA loss by $100 million. Lowered expansion saved another $100 million, giving McMinn back that $200 million loss.

"We're actually much better off in cash than before, and we have a program to decrease our losses by $20 million every quarter. If we can continue that through 2002, we will be EBITDA-positive by the end of 2002," he says.

This will enable Covad to obtain additional capitalization next year, McMinn believes.

"We have enough cash to get into next year, and the amount we need to get to a positive cash flow is a small enough number. I'm confident we can raise it. We can get it from private sources even if the public markets are not there."

New Paradigm's Mycio says McMinn is correct about this year.

"Things will get better this year. But the real problem is the first quarter '02. That's when they will have to recapitalize, and that's very iffy right now," says Mycio.

He also says that he does not believe Covad is safe from being bought. His bet on a buyer is SBC, since it already has bought a piece of the action.

"SBC is getting to know Covad if anybody is," Mycio says. "They are beginning to look at how best to utilize the assets."

However, Bear Stearns analyst James Henry says he believes Covad is in a very good position.

"Covad, and the ILECs, will face less competition, and will find acquisition opportunities at very reasonable prices," Henry predicts.

He adds that the enterprise value of the DSL sector stands at about $2 billion, down from $20 billion a year ago. That can only mean that bargains out there now just may be too good for anybody to pass them up.

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