Jun 4, 2001 12:00 PM,

The Good, the Bad, and the Ugly

James Molloy and Elizabeth McKeever

Stratification continues as the shakeout in the CLEC Corral rolls on

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While any utterance of the words “competitive local exchange carrier” still sends shivers down the spines of most analysts, recent activity in this sector suggests that amongst the thorns a few roses are alive, blooming and bigger than before. Since the end of third quarter 2000, CLEC consolidation has been trendy and bankruptcy even trendier, but the survivors of the “Shakeout at the CLEC Corral” have captured Wall Street’s confidence, additional capital and the valuable assets of fallen rivals.

Within the last seven months, 20 CLEC acquisitions have taken place, representing approximately $3.1 billion in disclosed deal value (Figure 1).

TABLE I CLEC Consolidations
Date/ Price ($M)	Company	Company Acquired
04/03/01 N/A	Connecticut Telephone	Digital Broadband Communciations
03/29/01 N/A	TELUS Corp.	William Communications Canada (WCCI)
03/23/01 135	AT&T	NorthPoint Communications
03/19/01 40	McLeod USA	Intelispan Inc.
02/28/01 N/A	CCC GlobalCom	Equalnet Communications
02/27/01 N/A	Arbros Communications	Comm South Cos. Inc.
02/22/01 10	GCI	Fiber Optic System of Worldcom (85%)
01/13/01 84	NTELOS Inc.	R&B Communications
01/10/01 1,948	Exodus Communications	GlobalCenter webhosting sub of GX
01/08/01 1.1	Corzon, Inc.	LecStar Communications
12/19/00 N/A	Verizon	OnePoint Communications
12/15/00 N/A	TELUS Corp.	Clearnet Communications
12/07/00 6.3	Net2000 Communications	Vision I.T. Inc.
11/27/00 195	Telephone & Data Systems	Chorus Communications
11/13/00 N/A	Omniplex Communications	MARZ, Inc.
11/08/00 2.1	Prime Companies	New Wave Networks
10/30/00 532	McLeodUSA	CapRock Communications
10/30/00 175	Smart City Networks	Vista United Telecommunications
10/19/00 N/A	Pac-West Telecom	Communications Specialists
10/16/00 N/A	GT Group Telecom	C1 Communications
TOTAL 3,129 (in $M)

Eleven CLECs have filed for Chapter 11 bankruptcy protection and at least four have officially closed operations (Figure 2).

TABLE 2 CLECS Bankrupt or Closed
Date	Company	Status
04/12/01	Actel Integrated Comm.	Closed Doors
02/23/01	ConnectSouth	Closed Doors
01/29/01	2nd Century Comm.	Closed Doors
12/29/00	Jato Communications	Closed Doors
04/27/01	Telscape International	Bankrupt
04/26/01	@Link Networks	Bankrupt
04/18/01	WinStar Communications	Bankrupt
04/03/01	Pathnet Telecommunications	Bankrupt
03/30/01	Advanced Radio Telecom	Bankrupt
03/22/01	e.spire Communications	Bankrupt
02/28/01	Equalnet Communications	Bankrupt
12/28/00	Digital Broadband Comm.	Bankrupt
12/08/00	NorthPoint Communications	Bankrupt
11/01/00	ICG Communications	Bankrupt
10/16/00	NETtel Communications	Bankrupt

Additionally, 16 companies have instituted major workforce reductions, affecting more than 4000 CLEC employees. Advanced Radio Telecom and HarvardNet undertook the most severe layoffs when they released an estimated 90% and 58% of staff, respectively.

Despite those statistics, the CLEC landscape is not entirely negative. Since the beginning of fourth quarter 2000, 28 CLECs received more than $6.6 billion of debt and equity capital (Figure 3).

TABLE 3 Financing
Date	Company	$ M/Type	Lead
04/23/01	New Edge Networks	78 Equity & Debt	GS Capital/ First Union Nat'l Bank
04/13/01	Net2000 Communications	190 Equity & Debt
04/06/01	Eschelon Telecom	10 Debt	GE Capital/ Fleet Nat'l/ JP Morgan
04/06/01	Pac-West Telecom	25 Vendor financing
04/03/01	BTI Telecom	90 Equity & Debt	Welsh, Carson, Anderson, and Stowe
04/02/01	Birch Telecom	105 Equity	KKR
03/22/01	Adelphia Business Solutions	461 Equity
03/20/01	US Carrier Telecom	25 Lease facility	CIT Equipment Financing
03/14/01	Vanion	10 Equity	Koch Ventures
03/12/01	Conversent Communications	186 Equity & Debt	FleetBoston/CIT Lending Services
03/01/01	ITC-DeltaCom	150 Equity	ITC Holding Company
02/05/01	Yipes Communications	200 Equity	Charter Growth Capital
02/05/01	NewSouth Communications	85 Equity	KKR/First Union/JP
01/30/01	ITC-DeltaCom	40 Lease facility	NTFC Capital Corp.
01/29/01	Time Warner Telecom	400 Debt
01/29/01	Time Warner Telecom	484 Equity	MSDW
01/22/01	Network Telephone	140 Debt	Lehman/Lucent
01/19/01	Globalcom	65 Equity & Debt	GE Capital
01/18/01	Time Warner Telecom	700 Debt
01/17/01	Telscape International	3.3 Vendor financing
01/16/01	Arrival Communications	19 Equity	Alta Comm/ Housatonic/BBC
01/15/01	BTI Telcom	20 Equity	CEO & WCAS
01/04/01	McLeodUSA	750 Debt	Salomon Smith Barney
01/04/01	Integra Telecom	41 Equity	Boston Ventures
01/04/01	Phonetime	1.5 Lease facility	Cisco Systems
01/02/01	Cavalier Telephone	175	No Lead
01/01/01	XO Communications	518 Debt
12/08/00	Teligent	250 Equity	Rose Glen Capital Management
12/07/00	Winstar Communications	1,020 Equity, Lease facility	Compaq/Microsoft/ CSFB/Cisco
11/28/00	Rhythms NetConnections	50 Vendor financing
11/14/00	IP Communications	312 Equity & Debt	VantagePoint Venture Partners
TOTAL		6,603

In January, the sector outperformed the Nasdaq and Standard & Poor’s 500. A number of leaders have emerged, including McLeod USA (MCLD), Time Warner Telecom (TWTC) and XO Communications (XOXO). These three CLECs have a market value of more than $10 billion (as of May 11) and $17.8 billion in combined total assets.

In addition, increased insider buyer activity among CLEC management teams is an encouraging sign that CLEC management views their stocks as undervalued. One example is XO Communications, where four executives purchased a combined $21 million on 1.39 million shares. Significant insider buying activity also occurred within McLeod, Primus Telecommunications Group (PRTL), PTEK Holdings (PTEK) and RCN (RCNC).

Consolidation has increasingly become the only option for a number of players, as the strong become 'hunters' and the weak become 'prey.'

Consolidation has increasingly become the only option for a number of players, as the strong become “hunters” and the weak become “prey.” The industry has further stratified into three tiers, which we have characterized as The Good, The Bad and The Ugly. Good companies can access capital markets and acquire weaker rivals. Bad CLECs are currently barred from capital markets, running out of cash, and potentially facing de-listing. Finally, the Ugly are those companies that are either already in bankruptcy proceedings or have closed operations.

The Good

These stronger players have recently been able to access funding, allowing them to load up their war chests to build out infrastructure and snatch up weaker competitors as they seek to acquire the critical mass needed in this asset-intensive environment.

McLeodUSA (NASDAQ; MCLD). One of the strongest companies in the industry, McLeod is staffed with a top-tier management team and, along with Time Warner, is one of two CLECs currently EBITDA-positive. In testament to Wall Street’s enthusiasm for McLeod’s ability to execute to plan, the company filed in January to raise $450 million in debt. It ultimately raised $750 million of 11 3/8% senior notes. This funding will sufficiently carry the company through to cash flow-positive operations in 2002, with $630 million in cash, $725 million in available credit and $375 million in internally generated operating cash flow. McLeod is also a top hunter in the industry, as evidenced by its $532 million acquisition of CapRock Communications last October and $40 million purchase of Intelispan in March. Additionally, McLeod’s insiders have purchased more than 3.7 million shares since November.
McLeodUSA website
Profile on Yahoo

Time Warner Telecom (NASDAQ; TWTC). Time Warner is the only CLEC besides McLeod that is currently EBITDA-positive and also maintains one of the least debt-burdened balance sheets in the industry. The company took advantage of the capital market opening in January and raised $1.1 billion of debt and $484 million in equity. A large portion of the debt capital is earmarked to pay off a $700 million bridge loan in connection with the August 2000 acquisition of GST Communications, Time Warner’s only major acquisition to date. With more than $400 million of additional capital available, few observers believe that the GST acquisition will be the last.
Time Warner Telecom website
Profile on Yahoo

XO Communications (NASDAQ; XOXO). Highlighted as one of the strongest names in the group, XO Communications raised $517 million of convertible subordinated debt, including a $67.5 million over-allotment. The company has also filed to raise an additional $2 billion in debt, equity, depository shares and a variety of debt securities and warrants. However, while XO is one of the best-positioned companies in the group, questions remain regarding its long-term ability to execute to plan due to a highly leveraged balance sheet. XO is currently saddled with more than $500 million of debt, in addition to the $4.4 billion on the books as of September 2000. The debt is not due until 2009, but XO anticipates being cash flow-positive by 2004, despite possible constraints on operations.
XO website
Profile on Yahoo

The Bad

The struggling second tier of carriers are in a fight to survive as they face similar capital requirements to the well-funded hunters but remain excluded from capital markets. Since last November, 16 CLECs have announced layoffs, representing more than 4000 employees and, on average, approximately 27% of their workforces (Figure 4).

TABLE 4 CLEC Layoffs
Date	Company	Number of employees	% of Workforce
04/17/01	Convergent Communications	400
03/30/01	Advanced Radio Telecom	200	90%
03/14/01	Videotron Communications	420	49%
03/09/01	Broadband Office	69	14%
03/05/01	Z-Tel Technologies	400	20%
02/23/01	Birch Telecom	308	18%
02/15/01	Alltel Corporation	1,000	4%
02/02/01	Covista Communications	N/A	10%
01/19/01	Net2000 Communications	N/A	10%
01/05/01	BTI Telecom Corp.	70
12/29/00	Covad Communications	400	14%
12/07/00	Northpoint Communications	248	19%
12/06/00	HarvardNet	280	58%
12/01/00	DSL.net	141	28%
12/01/00	Connectiv Connections	80	25%
11/08/00	Network Access Solutions	145	25%
Total		4,161

These reductions are a result of increasing pressure to minimize operational expenses and streamline processes.

Teligent (NASDAQ; TGNQE). With the departure of its high-profile CEO, former AT&T heir apparent Alex Mandl, Teligent has headed down the same bankruptcy path taken by many of its CLEC brethren. Teligent’s plan was to use wireless technology to deliver high-speed Internet services to offices in cities and urban areas.
Teligent website
Profile on Yahoo

On May 21, Teligent and its domestic subsidiaries announced that it had voluntarily filed a petition for protection under Chapter 11 of the U.S. Bankruptcy Code to reorganize its operations and financial structure.

Back in March 2000, the company went on the road to raise $500 million in a secondary placement and raised just $191 million. On the positive side, IDT Corp. (NYSE; IDT) has recently stepped in to pick up 34% of the company from John Malone’s Liberty Media Group. IDT has taken over management of the company and asked Mandl to step down, which could mean a swift trip into and back out of bankruptcy if IDT can develop an appropriate restructuring plan.

HarvardNet. In an attempt to avoid the fate of other CLECs, HarvardNet terminated all DSL operations in favor of Web hosting and managed services. After fighting to become a broadband provider, HarvardNet announced in December that it would lay off 280 people in its DSL group, representing 58% of its workforce. Mark Washburn, president and CEO, explains that “the DSL business is very capital-intensive, and the recent dramatic downturn in the financial markets makes it difficult to continue offering DSL services.”
HarvardNet website

The Ugly

The CLECs in the weakest tier have been forced to either declare bankruptcy or shut their doors as they have been excluded from the capital markets and unable to find suitors for their asset bases before cash ran out. Since the fourth quarter of 2000, three CLECs have closed operations and five have announced that they are in bankruptcy proceedings.

Jato Communications. Prior to closure, Jato Communications offered DSL broadband services such as Internet access, hosted applications and networking. Formed in 1998, Jato assembled its high-speed network through a series of alliances that involved a few hefty equity investments, totaling $84 million, from top industry players. Jato secured a line of credit from Lucent and partnered with Qwest in a $10 million equity deal. It also received $5 million from Global Crossing, $10 million from Microsoft and additional private investments from venture capital firms. However, in 2000, the company had to postpone its IPO, cut its 575-member workforce and scale back operations. It ultimately closed its doors in December as it was unable to access additional capital or find an acquirer.

e.spire (OTC BB: ESPIQ.OB). e.spire provides local and long-distance telephone service to small and medium-sized businesses. It also builds and leases fiber networks, and provides Web hosting and collocation services. The company filed for Chapter 11 bankruptcy protection in March. e.spire may be in better shape than many other CLECs currently in Chapter 11, as it recently secured $85 million of financing from a group led by Foothill Capital and Ableco Finance LLC. The company believes this financing should be sufficient to complete its restructuring process.
e.spire website
Profile on Yahoo

Future Outlook

An anticipated FCC ruling abolishing reciprocal compensation payments terminated to ISPs only adds to the challenges faced by the weaker players in the industry. Currently, incumbent LECs must pay CLECs for local termination of voice and Internet traffic that originates on the incumbent’s lines. However, incumbent LECs argue that terminating calls to local ISPs is not a local termination but rather termination of non-billable interstate traffic because the ISPs ultimately connect the calls to the Web. Elimination of these ISP termination payments would be extremely detrimental to the already cash-strapped CLECs.

Many venture capital firms will increase their stake in existing, successful portfolio companies as Wall Street continues to evaluate consumer demand for increased bandwidth and the shakeout of weaker CLECs. In February, Kohlberg Kravis Roberts (KKR) announced that it would provide an additional $85 million in financing to New South Communications, on top of $125 million.

KKR is currently in negotiations to inject an additional $100 million into Birch Telecom, following an earlier $60 million. Commenting at the recent CompTel show in Orlando about recent additional investments by venture capitalists in the sector, Shirish Lal, president of Broadwing’s broadband services unit, said: “They did what they had to do, which was double down on the best parts of their portfolio.”

Although the CLEC sector has experienced a dramatic shakeout over the past five months, the industry will continue to evolve, with only the strongest surviving. More CLEC consolidation activity looms on the horizon as the successful carriers strive to build out their operations and leverage the high fixed-cost assets of smaller competitors.

Closed capital markets to small and mid-sized CLECs and depressed valuations should yield additional bankruptcy filings and more failed operations. The few large-cap CLECs will continue to build out their networks, using the capital markets for growth and increasingly attractive stock prices for strategic acquisitions.
James Molloy is an associate and Elizabeth McKeever is an analyst at RCW Mirus Inc.’s Telecommunications Group, Boston. Their e-mail addresses are molloy@merger.com and mckeever@merger.com, respectively.
This article has been adapted from one that appeared in June 2001 issue of The Mirus Online Newsletter, Volume 2, Issue 2.

Visit RCW Mirus online.