Some CLECs Are Lucky: MSOs Rule Them
For competitive local-exchange carriers, now is a great time to have backers with deep pockets and a strong, supportive management team. But few are so lucky.
Why? Because the financing that supported rapid expansion in the CLEC sector all but dried up just about a year ago, when previously indulgent investors became impatient for signs of profitability. Today, emerging telecom companies are finding that loans are hard to come by, venture capitalists are investing elsewhere and stock prices have plummeted.
Industry insiders predict it will be at least three to six months — or possibly longer — before significant funding again becomes available.
But the financial clouds that darken prospects for the least-solvent CLECs could have a silver lining for those communications-service providers with their roots in the cable-television industry.
For instance, Adelphia Business Solutions Inc. and Time Warner Telecom Inc. — both legally independent businesses that sprouted from multibillion-dollar cable operators — are taking advantage of their progenitors' fiscal strength.
While a third cable-founded CLEC, Lightpath Inc., has not made the move toward going public, it may benefit even more directly as a subsidiary of Cablevision Systems Corp. Like Coudersport, Pa.-based ABS and Littleton, Colo.-based TWTC, Lightpath doesn't have to worry about whether external funding will dry up in the midst of new-service rollouts. (See related story, page 102.)
Cable-operator parents like AOL Time Warner Inc., which owns 44.4 percent of Time Warner Telecom, and Adelphia Communications Corp., majority owner of Adelphia Business Solutions, provide a level of financial and executive support that's tough for other CLECs to match.
Some CLECs already have declared bankruptcy and others risk running out of capital later this year, according to Current Analysis Inc. telecom analyst Jason Knowles.
"I don't think that's a fear for the ones that have cable parents," he said.
SURVIVAL OF FITTEST
Parent-company sustenance could buoy the cable-related CLECs as they pursue their business strategies during this industry-wide shakeout. It could also help them maintain momentum long enough to outlast their competitors.
"In the current condition of the financial markets, you couldn't use strong enough words to say how important it's been to have a combination of implicit sponsorship [from Adelphia Communications], along with the outright capital investment that's been made over the past six months, when capital has not been available to the emerging telecom industry," said ABS vice president of finance Ed Babcock.
The benefits are both real and perceived. In February, for example, cable parent Adelphia Communications Corp. bought $88.5 million worth of telecom assets from its overextended offspring, money that ABS said it would use to pay down debt. The telecom networks and equipment the CLEC sold are in California, Colorado, Ohio and Virginia — markets where it has curtailed its expansion plans. Last year, ABS scrapped plans to expand into 200 markets.
Instead, ABS will focus on expanding services in its original 22 markets and driving toward profitability in 53 other areas it's added over the last few years. It will also reduce capital spending this year to a maximum of $550 million, down from $675 million last year.
Adelphia Communications gives CLEC stability stemming from its 50 years in business and moral support in encouraging ABS to stick to its game plan and replicate the success it enjoyed in its original market. That's been tremendously important, said Babcock.
"They are not a casual investor and their support goes well beyond the 'smart money' that came into this industry a year ago and thought they would achieve higher than average returns," he said.
Though the CLEC hopes to avoid taking financial transfusions directly from the cable business, it welcomes less- direct support.
"A benefit Adelphia will provide us is they have a very deep and strong set of relationships with the commercial banks," the next logical place where ABS will seek the funding it needs until such time as it can generate a free and predictable cash flow, Babcock said.
"Independently, it would be rough for Adelphia Business Solutions to do that, but because of the relationship with Adelphia we think we can find a bank credit facility that will fund our business plan through 2002 and get us through this crunch in the emerging telecom industry."
HAPPINESS IS: FULL FUNDING
Meanwhile, Time Warner Telecom has access to $1.3 billion in cash and available credit, which means its current business plan is fully funded, said senior vice president and chief financial officer David Rayner.
"This means our cash on hand and available funding will be used for expansion of our fiber networks and revenue generation, instead of operating losses and debt service," he said.
But the current economic slowdown and widespread difficulties in the telecom sector could affect TWTC — at least over the short-term. That's because some of its customers are Internet-service providers, CLECs or digital subscriber line providers that are either bankrupt or in financial trouble. The company is taking steps to reserve funds to cover potential bad debts.
Still, TWTC has a number of advantages that caused UBS Warburg LLC financial analyst Glenn Waldorf to be positive about the company at the same time it lowered forecasts for five other CLECs.
For one thing, AOL Time Warner and TWTC equity owner AT&T Corp. (which inherited its stake from its acquisition of MediaOne Group Inc.) are "outstanding partners to have." The CLEC's own management and execution has been strong from year to year, and is improving.
And the fact that TWTC is fully funded has been extremely helpful in an unstable capital market, said Waldorf.
Both analysts and industry executives suggest that the current shakeout in the CLEC industry is necessary. "There was such an influx of money to the telecom sector that basically anyone with a business plan could get some, and there were some bad business plans out there," Current's Knowles said. "This weeding-out process is Darwinism at its best, and the strongest will survive."
NO QUICK RECOVERIES
How long before better days arise for CLECs? Estimates range from three to nine months, or as long as two years.
"I don't think anyone really knows right now," Knowles said.
In this tight fiscal atmosphere, investors have shifted their focus away from those competitive communications-service providers that plan the biggest and fastest expansion, according to industry analysts.
Those CLECs that are focused on generating returns for investors within a reasonable timeframe — even if that means scaling back on plans to add new markets and extend network infrastructure — can expect their support from the debt and equity markets to return sooner.
"Too many CLECs forgot that they weren't only supposed to grow — they were supposed to provide profit to shareholders, as well," UBS' Waldorf said. "When a company postpones profitability forever, or doesn't run the business to generate sufficient profit, there is no reason for anyone to own shares in the company."
Investors began to throw money at emerging telecom companies shortly after the passage of the Telecommunications Act of 1996, which deregulated the local-exchange industry.
The heyday continued through early 2000, fueled by soaring stock prices for those providers that chose to go public. But then investors came to grips with some difficult market realities, said Current's Knowles.
Most importantly, they realized that telecommunications businesses are capital intensive. Not only is it costly to build and operate a network, but new competitors faced significant challenges in making inroads into markets that had long been served by incumbent providers.
Nonetheless, investors initially rewarded those CLECs with national expansion plans. This practice encouraged CLECs to try to build the biggest service footprint in the shortest possible time. Ultimately, most incurred tremendous debt, while few showed near-term prospects of making money.
"These companies were expanding so rapidly that they kept taking on debt even though they weren't going to become [cash-flow] positive in the foreseeable future," Knowles said. "Wall Street took a harder look at these balance sheets and decided it couldn't shell out money like that any more."
Too much competition also cut into margins, lamented ABS president James Rigas, one of three brothers in the Adelphia founding family who are executive vice presidents at the parent MSO.
"If there is a silver lining to the fallout of the financial markets and the consolidation, it is that markets are becoming less competitive than they were a year ago, when financial markets were throwing money at every company out there," he said. "There were a lot of competitors in a lot of markets, and frankly, some of the pricing was irrational."
In the long run, the current consolidation will be a good thing for the quality of the sector, he added.
ANALYSTS LIKE THEM
Financial support from parent companies, well-regarded management teams and focused business plans have generated support for ABS and TWTC among Wall Street analysts.
The Street thinks those two CLECs will increase earnings at an average annual rate of 40 percent, according to information compiled by NASDAQ. Seven securities analysts who cover Adelphia Business Solutions suggested investors hold or buy the stock.
As of mid-May, 10 of 16 securities firms covering Time Warner Telecom gave it a "strong buy" rating, five rated the stock a "buy" and one suggested holding it.
TWTC is demonstrating it is "on a path to profitability," Waldorf of UBS said. "The company's focus isn't just building a strong national enterprise providing high quality service but one that actually generates a profit, too."
Waldorf also endorsed the company's "modest" leverage: 47 percent of total capital. This is important because companies typically pay down the interest on their debt after they've paid expenses like rent and employee salaries, but before they declare a profit.
"If too much cash goes to pay interest, ultimately they don't have enough profit," he explained.
Comparing first-quarter results for the company's historic operations (excluding the $690 million purchase of GST Telecommunications Inc. in January), Rayner said Time Warner Telecom Inc. revenue rose 47 percent, indicating strong growth in the core business.
But he cautioned that the troubles other service providers are having could hit Time Warner Telecom's revenue growth in the next quarter or two.
Time Warner Telecom targets local businesses with its services, which include "last-mile" broadband connections for data, high-speed Internet access, local voice and long-distance services. Customers include government organizations, universities, medical practitioners, utilities and other telecom service providers such as long-distance carriers, Internet-service providers, and wireless-communications firms.
By the end of this year, Time Warner Telecom plans to offer fiber-based telecom services in 44 markets; it currently has 39. The GST deal gave Time Warner Telecom an immediate West Coast presence and additional local-exchange experience.
Since the America Online Inc.-Time Warner Inc. merger and AT&T's acqusition of MediaOne and other companies, the lines between telecom and entertainment competitors have blurred, according to Knowles.
One relatively near-term result: residential customers will expect some providers to bundle their telecommunications and entertainment offerings, such as local-exchange and long-distance telephony, Internet access and pay television.
Time Warner Telecom traces to 1993, when Time Warner Cable began telephony operations as a competitive-access provider (CAP), offering certain services through its cable plant and systems owned by Time Warner Entertainment and the Advance/Newhouse partnership.
Four years later, a new management team expanded the telecom strategy to focus on providing switched services to business customers in the cable company's service areas.
ABS was launched almost nine years ago.
"Basically, we were trying to learn more about the telephony business. It was clear that everyone in cable needed to know more about telephony," said Timothy Rigas, CFO and executive vice president for ABIS and an executive vice president at Adelphia Communications Corp. The CLEC went public in May 1998.
While neither Time Warner Telecom nor ABS is profitable in the absolute sense of net profits, both are close to another business milestone: becoming cash-flow positive. Time Warner Telecom met this mark two years ago, while ABS reached it, in part, more recently.
A company becomes cash-flow positive when it still has money left after deducting from its total sales the amount spent on network and related costs for creating services, the cost of selling those services, and expenses for its sales force and administration of the business.
Time Warner Telecom has had positive cash flow for eight consecutive quarters, and ABS has seen cash-flow "profits" in its 22 original markets.
Both Time Warner Telecom and Adelphia Business Solutions continue to report net losses, but many other CLECs are still incurring much more significant losses.
"A lot of CLECs aren't selling enough product to justify the cost of providing that product, or the cost of the sales force and running the business," explained Waldorf. So, becoming cash-flow positive in this industry and at this time isn't bad.
STOCKS AREN'T SO HOT
Despite their competitive strengths and support from their parent companies, neither CLEC avoided the industry-wide collapse that pummeled stock prices.
When ABS (its ticker symbol is ABIS) began trading on the NASDAQ exchange in early May 1998, it carried a price of $17.375. On May 11, three days prior to announcing this year's first-quarter earnings, the stock closed at $4.03 — less than one-fourth its original price.
In the intermediate period between the IPO and now, ABIS traded as high as $67.50 on March 10, 2000, and as low as $3 toward the end of that year.
Time Warner Telecom (TWTC) fared better. Since its launch as a NASDAQ stock on May 12, 1999, at $20.75 per share, TWTC hit an all-time high of almost $90, also on March 10, 2000. Its bottom — $28.625 — came in April 2001.
In mid-May, TWTC got a nice pop, to about $50, after the Financial Times
said Cable & Wireless plc might be interested in making a buyout offer. UBS's Waldorf estimated an acquisition price of about $68 might tempt AOL Time Warner to sell. But he noted that TWTC's fundamentals hadn't improved since management warned about 2001's prospects in early May, and the stock closed at $40.95 on May 31.
The lesson may be that for now, at least, the CLEC industry remains volatile. But analysts say that ABC and TWTC —, beneficiaries of a cable industry legacy and ongoing relationships — appear focused on generating profits as they continue to build their own fiber network, whenever possible, and then connect new customers directly to it.
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