INVESTORS PUSH YIPES TO TAKE A MULLIGAN

Apr 1, 2002 12:00 PM, Glenn Bischoff and Vince Vittore

In one of his last acts as CEO, Yipes' Jerry Parrick took a page from today's corporate survival manual: filing for Chapter 11 bankruptcy protection and arranging for debtor-in-possession financing to get the metro optical Ethernet provider past a funding shortfall.

While the maneuver will give Yipes the leverage it needs to renegotiate a more favorable deal with its creditors, it is only part of the total solution. The company ultimately will need to rewrite its business plan to survive in a market segment that still shows a great deal of promise but has been hampered by slower-than-expected growth rates.

When the bottom dropped out of the economy, Yipes, like many telecom service providers, began to feel the pinch. Currently, the company needs about $100 million to reach cash flow break-even. In an interview last week, Parrick said investors have told him that they still believe in the company's value proposition, business plan and architecture, and were willing to stay out on the limb with him. They just didn't want to slide too far away from the trunk.

"They are ecstatic over our business," Parrick said. "They just don't like our balance sheet."

Parrick was booted upstairs to the chairman role last week, handing control of Yipes' day-to-day operations to former Chief Operating Officer Dennis Muse, who is now CEO. Sources inside the company said Yipes' board of directors decided several months ago that the provider's business was too complex for Parrick to operate on a daily basis while continuing to act as the company's liaison with the investor community. The Chapter 11 filing accelerated the transition to Muse.

Investors told Parrick they wanted him to cut costs to the point that Yipes needed only about half of the necessary funding to get to cash flow neutral. Voluntary bankruptcy is a convenient way to do it.

"The entire industry is re-rationalizing its costs, and our investors expect us to do the same," Parrick said. "Chapter 11 is just another mechanism to clean up the balance sheet."

Suppliers held all the cards when Yipes burst upon the scene two and a half years ago. The industry was awash with competitive carriers buying equipment and services as fast as they could be produced. Incumbent carriers also were buying, pushed by fear of losing customers to hungry competitors. Consequently, suppliers were able to negotiate terms that were favorable to them and less so to their customers.

"The vendors definitely had the upper hand," said Nick Maynard, analyst with The Yankee Group.

At the time, that didn't bother Parrick. He believed the demand for bandwidth-and the company's method of letting customers order the bandwidth they need when they need it, in one-megabit increments-would generate enough revenue for Yipes to meet its commitments to creditors and keep it on the path toward cash flow positive status.

Yipes' approach to Chapter 11 is endemic of the industry. Led by the poster child for quick restructuring, Covad Communications, some carriers are treating Chapter 11 as just another business strategy. For example, Digital Teleport filed for protection Dec. 31, despite growing revenues and a cost structure that had been significantly slashed. At the time of the filing, the company listed about $333.5 million in liabilities.

"You have that debt that's like a freight train coming at you," Paul Pierron, CEO of Digital Teleport, said last week.

St. Louis-based Digital Teleport took the unusual step of informing both customers and vendors that it was considering Chapter 11 in the months before the filing.

"If you do something at the last minute, it puts a bad taste in their mouths," Pierron said. "We were proactive. We showed them financial reports, we showed them very conservative projections and we continued to do business with people that we were doing business with."

But even with careful preparation like that, Chapter 11 will put a bad taste in investors' mouths, said Maribel Dolinov, an analyst with Forrester Research. "The creditors are going to have an issue with Yipes on this," she said. "There are some people who aren't going to get paid." That would be a crushing blow for telecom vendors on Yipes' creditor list that already are struggling (see table).

Nevertheless, Dolinov recognized why Parrick followed Covad's lead. "Too many service providers were funded, too much money was lost and now no one wants to fund the people who are around today," she said. "So if nobody is spending any money and you have a huge amount of debt, then the easiest thing to do is claim bankruptcy and see what happens."

But Pierron said operating under Chapter 11 adds stigma to an industry that's already become persona non grata to the investment community. Before filing for protection, Digital Teleport paid for a value assessment study and tried negotiating a pre-packaged Chapter 11 with debt holders. By then, however, the market had been damaged, and those on the other side of the table were showing little interest in investments that represented an increasingly smaller portion of their portfolio.

"[The study] wasn't given much attention," said Pierron. "I did phone calls with as many of the note holders as I could.

I could tell by the way the questions were coming back that they hadn't read the study."

Such reaction isn't necessarily surprising because the capital markets in particular tend to overreact on both ends of the cycle. In the current environment, the key is avoiding playing just to the investment community. Accordingly, a focus on the operations and the core value of the company has become even more important, said Pierron.

"If you don't have a good core value business, there is nothing on God's earth that is going to save you," he said.

That's why it could be hard for Yipes to emulate Covad's seemingly successful re-emergence from Chapter 11-unless Yipes makes some significant changes to its business model that address the crippling costs of bringing fiber laterals to the buildings it serves.

"That's going to be expensive, regardless of whether they get rid of debt," Dolinov said. "Stand-alone Ethernet providers are going to go out of business because they don't have enough money to support their structure."

In retrospect, Parrick said, Yipes focused too much on expanding its footprint and getting customers, and not enough on cost containment. However, Yipes' original cost structure for elements such as dark fiber, co-location space and real estate bear no resemblance to today's market conditions, he said.

"If I had it to do over again, I would have focused more on costs," Parrick said. "But we have a lot of great suppliers who are willing to work with us, and we have been renegotiating contracts with us for some months."

One solution: deploying Ethernet over existing T-1 or standard copper lines. Dolinov said the technology exists to do both, though she described the current muxing technology that makes Ethernet over copper possible as "inelegant."

"If Yipes changes the way it deploys Ethernet, maybe they can survive," Dolinov said. "But there's no indication they're going to do that. I think Yipes is going to go down."

Dave Schaeffer, founder and CEO of Yipes competitor Cogent Communications, thinks Yipes over-extended itself by moving too quickly into ancillary products such as managed Web hosting, firewall management and voice-over-IP services.

"If you try to be all things to all people in this capital environment, you generally don't make it," Schaeffer said. "Sixty-five percent of our customers would have no need for the types of services Yipes is providing," he said.

Parrick bristled at the criticism: "The amount of business we do in managed firewalls and Web services is reasonably small."

The Yankee Group's Maynard also agreed that Yipes hasn't taken on too much and simply hasn't been given the time to gain necessary traction. "They need another year to year-and-a-half to gain the customers and revenue needed to show they have the ability to scale this thing," Maynard said. "If they can get there, they'll be able to prove to the market that Ethernet is a viable option for metro services."