Waiting for the Thaw

Posted 09/01/2001

Waiting for the Thaw
Outlook Remains Bleak for Industry Consolidation Activity

By Gail Lawyer

Late last year, predictions abounded that 2001 would see some of the greatest consolidation in the competitive telecom industry's short history. Many people expected it to happen through mergers and acquisitions, in which stronger CLECs, BOCs, long-distance companies and foreign PTTs would pick up assets and customer bases of other CLECs to expand or extend their service offerings and territories.

But the golden age of telecommunications quickly turned into an ice age, as a number of factors combined to make merger and acquisition (M&A) activity a less than attractive method of growth.

The nation's lackluster economy this year is resulting in less M&A activity in general across all business sectors. However, the competitive telecom industry has many other strikes against it that have further slowed any potential consolidation activity.

For instance, strong CLECs lack the cash needed to buy other companies. Business plans across the board have been scaled back as the capital markets remain unwilling to continue funding the CLEC business model. Most companies are saddled with crippling debt that makes them unattractive to potential suitors. And now, many CLECs have filed for bankruptcy, bringing assets to market at much less than they could be purchased for in a traditional M&A deal.

"Potential acquirers are standing back because they're questioning the whole viability of this business model," says Gregg Clevenger, senior vice president of strategy, planning and business development at Mpower Communications Corp.

Not only is there uncertainty about the soundness of the CLEC model, but potential acquirers also are finding themselves cash strapped, making them more focused on ensuring that their existing operations are running smoothly and making a profit, rather than seeking ways to expand into new territories or add new services offerings. BOCs are slowing down their attemts to get long-distance approvals. Large IXCs are occupied with cleaning up their balance sheets and spinning off various divisions. And European PTTs are in debt as a result of 3G license auctions.

While these factors have played a role in slowing M&A activity, it hasn't ceased altogether. With stock prices down considerably from what they were at the height of the CLEC frenzy, there are many bargains.

Take, for example, the interest in AT&T Broadband Inc.'s assets, after the hostile bid attempt by Comcast Corp. And IDT Corp. was considering becoming a majority owner of Teligent Inc. and ICG Communications Inc., both of which are in bankruptcy.

As for actual mergers, in early June, Cavalier Telephone purchased Conectiv Communications, the CLEC division of utility company Conectiv Inc.

"This company was valued much higher a year ago than the day we bought it," says Mark Zitz, Cavalier's region president. "We couldn't have done this a year ago."

Financial details of the acquisition were not released.

Conectiv's network was a natural extension of the Cavalier footprint. "It really closes our network between the north and south, and most important, the asset quality was outstanding," says Zitz, noting that Conectiv had an 800-mile fiber network that was up and running with customers.

Many other CLECs are purchasing related companies, such as web hosters, ISPs, and interconnects, that can expand service offerings to end users. Allegiance Telecom Inc. acquired several companies that are into web hosting, collocation or other Internet-related services (see chart "Sealing the Deal", page 20), while Eschelon Telecom Inc. is constantly on the lookout for interconnect companies that can supplement its telephony offerings in the markets it serves.

The Waiting Game

With so many companies considered bargains, why is there so little M&A activity surrounding the CLECs today?

For one, with bankruptcy filings an imminent concern for many CLECs, stronger service providers are playing the waiting game to see how big a bargain they might get.

"Companies not in bankruptcy are getting cheaper and cheaper every day," says Larissa Herda, president and CEO of Time Warner Telecom Inc. "Many are waiting until they go into bankruptcy."

Time Warner did that when it purchased the assets of GST Telecommunications last fall for $690 million. "Time Warner looked at GST for about a year and a half before buying the company's assets after it filed for bankruptcy," she adds. "We bought GST assets because they were complementary to what we had, and the business GST was in was fundamentally the same we were in."

However, not all assets are made the same, and it is possible that many may sit unclaimed, even at the fire sale prices offered in bankruptcy.

We would be interested "if it's an asset we might need in the future, was at a reasonable price, and was easy to synthesize into our network," says Wayne Rehberger, CFO at XO Communications Inc.

But sometimes even the most well-intentioned plans for purchasing assets don't work out. Look at the situation Mpower found itself in with the markets and associated equipment it got when it acquired Primary Networks in mid-2000. Faced with the need to cut operational expenditures, Mpower decided to get out of the Midwestern cities it had entered through the purchase of Primary.

"When we decided that we needed to take further steps to make sure we were self-sufficient, we looked at every market in great detail," says Clevenger. "Those markets, for demographic reasons and the way the networks were built by Primary, from a margin perspective, weren't as efficient. As we looked at the long-term contribution, they weren't as robust as the markets we wanted to keep."

In more cash-flush times, Clevenger says, those markets would have added tremendous value to Mpower's overall operations. But under today's conditions, they were more like a "weight around our ankles," he adds.

Another factor slowing M&A activity is that prices of many CLEC stocks are below a dollar, indicating a significantly lower value than a company may have been able to receive in years past.

"No one wants to sell when their share price is low," says Glenn Waldorf, equity research analyst at UBS Warburg LLC. "There are so many operational issues hitting the industry. Companies that thought they had their act together realized, as the quarters went by, that they had more problems than they anticipated."

While the low share prices obviously make the companies an attractive target, the amount of debt many of these companies are carrying poses an enormous obstacle for potential acquirers.

"If I have a funded plan, I don't want to make it an unfunded plan because I buy something," says Richard A. Smith, Eschelon's president and COO.

"Debt is the number one issue," says XO's Rehberger. "There has to be something in it for the acquiring company ... and they've seen that it is not economically smart to acquire a company because they're going to lose money and be burdened with debt."

"Outside carriers don't want to touch this group with a 10-foot pole because of the dilution," says Ken Hoexter, managing director at Merrill Lynch & Co. Inc. "I truly do not believe that M&A are a near-term phenomena because of the continued losses of the group."

A further deterrent is the potential acquirer's lack of cash available for anything beyond day-to-day operations.

"Most of the CLECs out there today, if they've announced they're fully funded, then they're fully funded as long as they execute," says Eschelon's Smith. But in the execution, those business plans rarely include the addition of new businesses through acquisition.

"The unfortunate part about this is that companies need cash [to complete acquisitions]. They need cash to run that other guy's business, but they have enough trouble funding their own business," says UBS Warburg's Waldorf. "There are going to be lots of assets in which there is no interest because no one is willing to spend cash on them."

But even if the acquisition target has the right assets and a low-debt load, and the potential acquirer is flush with cash, there is another hurdle companies consider to ensure that it's a match made in heaven.

"The other thing that acquiring a company does ... is that it takes a lot of management bandwidth," says Time Warner's Herda. She believes that the time it takes to integrate a separate company into existing operations may hurt the company's focus and business plan. "We only have so many people, and this is a people business," she adds.

"Doing an acquisition and being involved with the integration is a full-time job, and I already have one trying to run my company," Smith adds. "I think that the fact that integrating companies is harder on the CLEC side is keeping companies apart, and will keep them apart even if they get stronger financing."

What the Future Holds

As long as the economy continues its slump, most industry observers believe the chances for increased M&A activity are slim. However, some expect that there will be consolidation among some of the healthier CLECs over time, as well as vertical mergers designed to strengthen remaining companies service offerings.

"I think over time, we'll see M&A pre-bankruptcy activity heat up again," says Phil Yawman, executive vice president of corporate development for ChoiceOne Communications Inc. "It's all part of a natural path towards our industry being one of a handful of national and regional survivors."

Some industry watchers hope there is consolidation, so stronger players have an even better chance of being among those survivors. "There is a CLEC model, and economies of scale and consolidation would make sense," says Waldorf.

Vertical mergers make much more sense, says Royce Holland chairman and CEO of Allegiance Telecom. Inc. Holland and others, given the conservation of cash that is now occurring and the fact that those types of mergers typically require less time-consuming integration.

"We do see [vertical mergers] happening," says Eschelon's Smith. "If we wanted to get into web hosting, we could benefit by someone who could do that, and we could run it as a separate division. That's what we do when we buy our interconnect companies. We know how to integrate that and it's much simpler than buying a full CLEC."

Plus, adding on new services through M&A can be beneficial in the long run, and make a company more likely to prosper in tough economic times. "I think companies that have a well-rounded product line have been able to navigate this economy a little better because when one product line or business wasn't doing well, there are two or three others that they can rely on," XO's Rehberger adds.

• Despite the slowing economy and declining growth rates in the fiber optics industry, first-mile fiber connections to multitenant office buildings remains a strong growth area, according to a report by optical marketing research and consulting firm Communications Industry Researchers Inc. (CIR, www.cir-inc.com). While CIR ultimately sees the ILECs dominating the business landscape, the new fiber-based CLECs and BLECs are providing the impetus for growth in next-generation optical access technology and services. CIR's report, "Optical Access: Next Generation Technology and Services in the First Mile," predicts that "optical buildings" will spur the domestic optical access systems market to surpass $2 billion by 2005. The report also finds that the number of fiber-connected buildings will grow from 21,000 in 2001 to more than 43,000 in 2005. CIR also believes that services such as Optical Ethernet will enjoy rapid growth over the next few years, reaching almost $900 million in 2005.

• Covad Communications Co. (www.covad.com) shut down its BlueStar Communications Group Inc. subsidiary, which the company acquired in September 2000. By doing so, Covad estimates it will reduce its operating costs by about $75 million during the next year, aiding the company's efforts to achieve profitability and extend its cash until July 2002.

• DSL.net Inc. (www.dsl.net) revised its operating plan so that it will need less than $40 million of additional capital to achieve a cash flow-positive position. The company also expects to reduce cash burn to less than $4 million per month by the fourth quarter of 2001. DSL.net laid off about 90 employees and planned to reduce its number of operational COs by about 250.

• 360networks Inc. (www.360.net) filed for bankruptcy protection in Canada and the United States. The company will use its $155 million of unrestricted cash, cash equivalents, short-term investments and marketable securities to maintain service to existing customers in North America. The company says it believes it can complete its North American network using its cash and current backlog of contracted revenues. 360networks also laid off 800 people throughout North America, Europe, South America and Asia.

•   Unisphere Networks Inc. (www.unispherenetworks.com) and BroadSoft Inc. (www.broadsoft.com) cancelled their planned merger, as a result of market conditions. The merger was going forward on the condition that Unisphere would do an initial public offering. But since that has not occurred, the companies announced that it was in their best interests to terminate the agreement. Unisphere and BroadSoft say that they would continue working together as strategic partners in joint sales and marketing efforts.

• Williams Communications Inc. (www.williamscommunications. com) will invest $20 million in cash and $10 million in services in iBEAM Broadcasting Corp. (www.ibeam.com) in exchange for convertible preferred stock representing a 49-percent ownership of the company. Under the agreement, Williams will become iBEAM's preferred provider of IP transit services.

• CopperCom Inc. (www.coppercom.com) secured $65 million in a new round of financing led by venture capital firms Advent International Inc. (www.adventinternational.com) and Technology Crossover Ventures (www.tcv.com). The funding will support CopperCom's continued growth in all areas of the company including operations, marketing, and research and development. The company also announced that it is centralizing its corporate management in its Boca Raton, Fla., headquarters. The company will maintain its Santa Clara, Calif., and Raleigh, N.C., offices as key development centers for its voice-over- broadband access and softswitch technologies.