Jun 4, 2001 12:00 PM,

A hard year at the office

by Robert West and Michael Ivie

Remember 12:01 a.m., Jan. 1, 2000? All of us with our fortunes linked to the telecommunications industry breathed a collective sigh of relief. Our wireless phone still provided the same scratchy quality, the Internet still routed obnoxious spam as efficiently as ever and when we picked up our phone receiver we heard the most humble, but reassuring, sound in telecom: local dial tone.

Had by the hype?

In 2000, the lending community was treated to a heaping helping of old-fashioned chagrin. There is no question that much of the flood of equity into competitive telecommunications in 1999 was based on enthusiasm for the short-term returns being realized by the Internet-centric technology segment of the market.

Lenders, more at home with the Old Economy, were under pressure from borrowers and their equity investors to suspend traditional underwriting practices and bow to the evolving tenets of the New Economy.

When the dotcom bubble burst, and telecom followed suit, it triggered a wave of pessimistic sentiment that pervaded the market, and many re-examined their confidence in newly coined maxims such as “Supply creates its own demand” and “If you build it they will come.”

Most financial institutions are under the close scrutiny of government regulatory agencies. These regulators are charged with protecting the financial health and integrity of the individual institution and the money and banking system as a whole. Obtaining regulatory and internal risk management support for new business lines, especially those associated with unproven business models, is often a slow and arduous process. But when problems occur, regulators and internal reviewers react very swiftly, sometimes recommending — if not requiring — that an institution reduce its exposure in certain areas immediately.

Lenders rely heavily on the cooperation of other financial institutions to underwrite and distribute deals. When more than a few institutions begin cutting back their lending limits to a particular industry, it creates a ripple effect that reduces the overall availability of credit.

Failure to execute

Tremendous demand exists for advanced telecom services in the U.S. and globally. However, CLECs have demonstrated that execution risk is much greater than anyone realized. Selling services and delivering them have proved to be two distinctly different challenges.

First, provisioning delays have been disastrous. It is now clear that the incentive of Section 271 approval to offer in-region, inter-LATA long-distance service has not been sufficient to encourage the RBOCs to promote competitive access to their networks. Many CLECs have found RBOC provisioning response times to be very discouraging. Even after receiving 271 approval, as in Verizon's much-touted case, provisioning problems have persisted despite the threat of fines, or even revocation of the new long-distance authority. This has resulted in growing backlogs and frustrated customers.

Moreover, the delay in revenue recognition caused by the backlog has increased the cash burn rate for many CLECs, further eroding their liquidity and jeopardizing their relationship with lenders. Complaints to state public utility commissions and even lawsuits against the RBOC are common in every state. In the potentially lucrative multiple tenant building market, CLECs have often met heavy resistance from property managers and building owners who have either refused access to their buildings, charged unreasonable fees or maintained they had given the incumbent LEC exclusive rights to access.

Second, CLECs have also had trouble provisioning due to their own poor operations support systems (OSSs). For many CLECs, order management, service provisioning and billing are not well integrated. Local service requests were often submitted to the ILEC on paper forms. Without an adequate follow-up system, it was too easy for the ILEC to delay provisioning or even lose orders. Many OSS systems failed to electronically link and error-check the separate ordering, provisioning and billing modules. In addition, legitimate market segmentation strategies were abandoned in the rush to tap the hottest markets first. Many CLEC business plans were appealing to lenders because the company had carefully analyzed the demographics of a market, considered the competition and had a specific plan for market entry.

But between 1999 and the end of 2000, it was not uncommon to see a management team radically depart from that strategy and put pressure on lenders to approve more markets, or different markets than originally planned, often in more competitive areas. This frequently left stranded costs and led to higher operating losses associated with new market entry.

Competition from the ILECs and other competitive providers has been underestimated. Competition for DSL services, for instance, has resulted in most CLECs having to significantly lower their pricing for this service, often to unprofitable levels.

In retrospect, it was probably a little presumptuous for all of us to expect that the ILECs would gladly hand over their market share without attempting to defend themselves, especially in urban areas. To the extent that CLECs threaten the ILECs' lucrative T-1 service, we can expect to see further resistance and price competition.

And speaking of profit issues, fundamental flaws have been exposed in the cost model. In some cases it has just proved much more expensive to run a CLEC than people thought. Truck rolls are more common than expected. Provisioning is more difficult, which requires higher-than-expected staffing levels to coordinate and monitor service cuts with the ILEC. Customer acquisition costs have been higher than expected, and customers have demanded new products such as Web hosting, which require unplanned capital expenditures. Poor-quality ILEC trunks and underestimated traffic loads have often led to unplanned purchases of fiber to overcome capacity constraints.

Moreover, growth was excessive and often unfocused. Just about any Business 101 class explains how important it is for a company to manage its growth rate to avoid overwhelming its financial and physical resources. In 1998 and 1999, it seemed as if the influx of new capital would never end. It really didn't matter if a CLEC burned through its capital to build more fiber, open new markets or make new acquisitions not in the original plan. Many telecom failures in 2000 were the result of excessive and unfocused growth that created large funding gaps in the business plan that could not be bridged in a tight capital market.

In many cases management teams lacked the necessary technical skills to deliver the product. Finding talented management and technical staffs that actually understand local telecommunication networks is more difficult than expected. Most CLECs eschewed hiring talented ILEC employees, despite their decades of experience in local telephony. Actual telecom experience seemed to take a backseat to entrepreneurship.

What to expect now

Going forward, lenders will expect a few things from CLECs. First, OSSs — whether outsourced or in-house — must be able to integrate and authenticate data between the big three OSS modules: ordering, provisioning and billing. Electronic bonding with the ILEC will be mandatory, except in areas where this is technically infeasible. If a paper system has to be employed, sufficient staff needs to be hired to manage this process effectively.

Also, CLECs should be able to provide “same store” sales data to allow the lender to evaluate performance in each existing market. Lenders will scrutinize market segmentation and market entry plans much more carefully. Variation from the plan will be strongly discouraged without justification. Lenders will be leery of claims of little or no competition in higher-tier urban areas. Expect lenders to challenge penetration assumptions.

It will be increasingly important for CLECs to stay focused and do a better job managing growth. Excessive growth rates that lead to unexpected operating losses and covenant defaults will be viewed seriously. Lenders are going to expect a company to manage its sales activities to add customers at a rate that does not overwhelm financial capital. Lenders prefer to be treated as partners. They expect to be consulted before new growth initiatives are begun, rather than being pressured to provide additional capital after the fact.

In addition, a CLEC's management team should be fully assembled before trying to raise new capital. The tactical management should have actual experience in delivering the services the CLEC will sell.

Furthermore, CLECs should expect to put a higher proportion of equity into new deals unless they are providing credit enhancements such as guarantees from strong parent companies.

While each deal is different, CLECs shouldn't be surprised to see 40% or higher equity and deeply subordinated debt required for a new project. Absent strong credit enhancements, CLECs will continue to see LIBOR spreads hover near 400 basis points for new projects, highly leveraged deals or restructuring due to covenant defaults. Commitment fees should stay well north of 100 basis points for the foreseeable future.

Lenders are going to be much more interested in monthly monitoring of operating performance. Loan covenants will probably be stricter. Waivers of significant violations will be harder to obtain without concessions. Limitations on new investments and new market expansion will be vigorously imposed. CLECs will be held accountable for EBITDA (or maximum EBITDA losses) on a market-by-market basis and an aggregate level.

In addition, lenders will be less impressed with subscriber and access line growth due to new market additions and more impressed with cost control and overall performance against originally projected benchmarks. If CLEC management can't resist listening to the siren song of the venture capital markets, then lenders may have to restrain them.

A renewed commitment to competition

The events of the past year have left lenders, investors and telecom companies a little wiser. But it is clear that the market opportunity is there. There are about 192 million local telephone lines in the U.S. producing total annual local service revenue of over $100 billion.

According to the FCC, CLECs captured 6.7% of the local market through June 30, 2000, up from 4.4% at the end of 1999. Many analysts are predicting nationwide CLEC market share will rise as high as 25% to 28% by 2005 with total local service revenues of nearly $40 billion. The share of local service revenues going to CLECs has continued to grow, reaching 5.8% in 1999 (latest report by FCC). There is even higher potential in data services. IDC projects that Internet service revenue will grow to more than $60 billion by 2004. CLECs, because of their more modern data networks, are poised to receive a substantial share of that growth.

Provided the CLECs correct some of the mistakes they've made in the past, it is hard not to be encouraged by the potential offered by this industry. Although lenders will become more discriminating when lending to this sector, CLECs can expect continued support from the credit community.

Robert West is senior vice president of the communications division of CoBank in Greenwood Village, Colo. Michael Ivie is credit manager of the communications and energy banking group of CoBank. Their e-mail addresses are rwest@cobank.com and mivie@cobank.com. Jaimee Untiedt, credit analyst in the communications and energy banking group of CoBank, contributed to this article.