The end of easy money?: CLECs pile on the debt

At one time, the sure-fire way for a competitive carrier to run into financial trouble was to only resell services and play price arbitrage by undercutting competitors by 15% to 20%. That model proved to be good for short-term growth but not so good for sustaining a business.

Nowadays, facilities-based carriers are having problems. The recent financial misfortune of GST Telecommunications, combined with the rise in interest rates, have brought the issue of equipment and other spending by competitive local exchange carriers (CLECs) to light: Like a credit card user with a huge balance, are CLECs overextending themselves?

True, telecommunications always has been a capital-intensive business. Debt usually represents 60% or more of the capital structure of a telecom company, and new carrier buildouts are characterized by huge capital expenditures and often two to three years of negative cashflow.

But the ease with which CLECs have been getting vendors to finance equipment purchases and equity investors to pour more money into their businesses will not last forever. For example, equipment vendors may become more careful in which companies they finance. Already, Lucent Technologies is under fire for the state of its accounts receivables and its vendor financing program.

When Deborah Hopkins became Lucent's chief financial officer a few weeks ago, Wall Street analysts were quick to point to degradation in customer financing and payment terms as one area hurting the company's balance sheet. "[Lucent's] receivables and vendor financing have got to be reigned in," said Steven Levy, an analyst with Lehman Brothers.

Lucent had $1 billion of cumulative drawn vendor financing at the end of its March quarter, said a company spokeswoman. And although Lucent wants to make favorable financing arrangements for carriers, a key criterion is the ability to resell the financing to financial lenders, which may be affected by the rise in interest rates. "We don't want our vendor financing to impact our A credit rating," the spokeswoman said.

Outsiders say large vendors such as Lucent and Nortel Networks can exacerbate the problem. "Nortel's and Lucent's loan rates are very competitive," said Paul Demerly, president and CEO of Napa Valley Consulting Group, a strategic adviser to CLECs. "[They] do what they have to do to sell their boxes."

Venture capitalists say companies would be crazy not to use vendor financing, Demerly said. "For the VCs, the more facilities a company has, the more they like it. If the company goes belly up, they could sell the network in place to another CLEC or have it sold in the secondary market. They're not going to be out the whole enchilada."

In short, it seems that the executive management teams of CLECs have to watch spending and debt levels. The two CLECs with the largest capital expenditures for 1999 - McLeodUSA and Winstar Communications, according to New Paradigm Resources' "CLEC Report 2000" - also already have raised a combined $2.5 billion in private debt in 2000, half the industry's total.

What are the potential pitfalls in a debt-focused strategy? Signing ill-advised restrictions and covenants is one danger zone. Just ask George Schmitt, chairman and CEO of e.spire. For the quarter ended March 31, e.spire was not in compliance with revenue and adjusted EBITDA benchmarks contained in its $200 million senior secured credit facility obtained in August 1999. The syndicated bank group agreed to give e.spire until June 15 to renegotiate the debt agreement.

"The EBITDA loss number was set way too aggressively," Schmitt said. "There was no chance that this company could do business and not have any hiccups. I could not figure out how anybody would have signed for those covenants," he added, speaking of former management. Schmitt is confident he can renegotiate the debt without drawing on other available credit facilities to the company.

In the meantime, Schmitt has placed network expansion on hold. "We are going to concentrate on selling profitably, making profitable sales in all the cities where we currently have either switched or non-switched facilities."

Of course, equipment isn't the only line item where spending can run amuck. e.spire plans to cut between $5 million and $10 million this year in areas that don't impact the business directly, Schmitt said. For example, the company occupies a building with a rent tag of $5 million annually and last year spent more than $1 million on headhunters. And the company recently closed a New York office that housed legal staff.

Debt isn't the only way to finance a network buildout. VCs and buyout firms are gobbling up large new equity issues by CLECs. In April, ICG Communications issued convertible preferred stock and warrants to affiliates of Liberty Media; Hicks, Muse, Tate & Furst; and Gleacher Capital Partners for a combined $750 million. The money will be spent on ICG's expansion plans into 22 metropolitan areas in the U.S.

But what if CLECs fall out of favor as an attractive equity investment? Only the strong will survive, said equity analysts. CLEC stocks have tumbled 50% since the NASDAQ's high on March 10.

"As we enter the third month of the sector's decline, we look for quality companies to emerge from this trough," said a report by Goldman Sachs analyst Frank J. Governali. "We believe these will once again be stalwart competitors such as Allegiance, Nextlink and McLeodUSA." And as valuations fall and access to capital tightens, "we would not be surprised to see cash-flush CLECs use this market dip as an opportunity to expand and strengthen their businesses," Governali said.

One alternative to vendor equipment financing is a more explicit form of risk sharing, said Bart Schachter, general partner at Blueprint Ventures. Because vendors essentially take an equity interest in carriers by lending them money to buy equipment, the concept is current practices.

For example, Schachter said, a carrier could pay a per-month fee on customer premises equipment instead of buying it outright. "That's a true `smart build' for the customer premises - the equipment provider becomes the service provider," he said.