ColLECtive anxiety

Now that the dot-com bashing season is over, the "Chicken Little" pundits need another industry group to cackle about. Lo and behold, they don't have to look too far. In case you've been locked up in a central office somewhere in Butte, Mont., note this: The stocks of CLECs are in free-fall. On a market cap-weighted basis, CLEC stocks are down 36% in 2000, vs. a 3% decline in the S&P 500 and a 13% decline in the NASDAQ.

Moreover, the CLEC downturn has more than just negative investor sentiment behind it: The smart money has good reason to be concerned about a market sector in which the pool of quality executive management is shallow, availability of new capital is lacking and recurring revenue sources such as reciprocal compensation are drying up.

Signs of a shakeout are already appearing - including the acquisition of competitive carriers for Web-based assets (Intermedia), downward revisions in earnings forecasts (Mpower and others), strategic investments by top-tier carriers (Verizon's and SBC's stakes in DSL providers), an exodus of top-level management (2nd Century, Teligent) and outright failure (GST). But maybe all the doom and gloom is overblown.

Not every CLEC will stoop to taking stake money from an ILEC, exit stage left through a merger or choke on its own financial miscues. Indeed, one analyst I talked to said the media are misrepresenting the receptivity to CLECs in the capital markets.

The rash of CLEC earnings disappointments are largely related to execution issues and not underlying fundamentals for the entire group, according to Trent Spiridellis, analyst at Banc of America Securities."Industry skeptics" are generalizing the funding problems of these service providers and unfairly penalizing those CLECs that have sufficient capital to fund their business plans into and beyond 2002, Spiridellis says.

He includes Allegiance, Focal, McLeodUSA and Time Warner Telecom in this lucky group, and says Adelphia Business Solutions, ITC^DeltaCom and Nextlink will receive capital infusions in the next six to nine months, allaying their capital concerns. On the other hand, the liquidity positions of Electric Lightwave Inc., e.spire and ICG are not as rosy, as their funding could run out by the first quarter of 2001.

Well-defined strategies and quality management teams are other important ingredients of a CLEC with survival prospects. In addition, investors should look for the percentage of revenue generated from Internet-related reciprocal compensation. Downward pricing pressure on reciprocal compensation rates may get worse as the House of Representatives considers H.R. 4445, which would exempt dial-up traffic bound for ISPs.

Reciprocal compensation continued to be a "material portion" of sales in the second quarter for Adelphia (10%), ELI (17%), Focal (35%) and ICG (22%), according to a report by Mark Kastan of Credit Suisse First Boston. True, the quarterly percentages are declining as ILECs negotiate cheaper contracts, but what's going to replace that slice of the sales pie?

Vendor funding levels are another important line item for gauging the CLECs that are here to stay, especially in the wake of Ciena's $28.2 million write-off of uncollectible receivables from European carrier iaxis.Vendor money could become less free-flowing and more expensive in the months to come, cutting into the pace and breadth of CLECs' network buildouts.

The mistake, though, is in assuming that vendors, regulatory snafus or the public equity markets will be the ultimate arbiters of CLEC survival.

Private and strategic equity investors are still interested in the competitive provider businesses. And it doesn't hurt that the poor performance of already-public CLECs gives these investors leverage in negotiating valuations and governance. Sure, some CLECs might give away the farm in return for some operating cash, but at least they'll gain some time to cultivate their budding businesses.