Two DSL carriers, two Chapter 11s, two very different results

In a dichotomy that offers important lessons for the telecom market's struggling inhabitants, DSL service provider Covad Communications is being hailed as a pioneer for its financial restructuring efforts even as the demise of fellow DSL player Rhythms NetConnections gets chalked up as just another economic casualty.

For its part, Covad is pre-negotiating its Chapter 11 filing with bondholders in a manner that will leave the company debt-free and on track to be cash-flow positive two years.

"It's going to be a model," said David Rosner, partner with Kasowitz Benson Torres & Friedman, representing Covad bondholders. "I would be very surprised if you don't see other companies do this."

By contrast, Rhythms NetConnections, which filed Chapter 11 two weeks ago, signaled the beginning of the end by sending 31-day termination notices to its users last Thursday. Rhythms' silence about its bankruptcy proceeding--"We're not doing any interviews about this," said a spokeswoman--is a stark contrast to the almost-celebratory mood of Covad officials.

Covad's bondholders forced the bankruptcy issue in April by threatening to sue the DSL provider for ignoring their fiduciary responsibilities. By restructuring, Covad avoids legal costs, bondholders receive at least some return on their investment and the company is able to focus on operations, said Jeff Moore, senior analyst at Current Analysis.

A MATTER OF PERSPECTIVE "Covad has really blazed a trail here. "It's a win-win proposition because the bondholders are getting a reasonable return on their dollar, while Covad is getting a clean slate and a real opportunity for recovery." --Jeff Moore senior analyst Current Analysis 'If your business model is, "We're going to take people's money and not pay it back--and they're going to be happy about it"--then yes, they've proven that that is a successful business model.'  -- Mike Goodman senior analyst The Yankee Group

"Covad has really blazed a trail here," he said. "It's a win-win proposition because the bondholders are getting a reasonable return on their dollar, while Covad is getting a clean slate and a real opportunity for recovery."

A majority of Covad's bondholders have agreed to retire the DSL provider's $1.4 billion debt load in return for stock that could represent 15% of the company and $283.3 million in cash. Covad will file Chapter 11 to get a bankruptcy judge's approval of the plan, which would make it effective for the remaining bondholders, said Covad Chairman and Co-founder Chuck McMinn.

"This is a big first step to eliminating any doubt about our financial viability," McMinn said. "The remaining step is to raise the incremental $200 million required to fund our business to cash-flow positive [in the third quarter of 2003]."

Covad's previous restructuring plan required the company to raise $400 million to $700 million-a tough proposition in a tight capital market. Raising a $200 million investment for a debt-free company with $250 million in available cash will be much easier, McMinn said.

From our June 4 issue Charles McMinn by Chris Sewell

"[Any new investors'] money is not coming in below $1.4 billion but is coming in as new money in equity that is much higher up on the list of priorities," he said. 

Although they are receiving only 19¢ on every dollar owed, bondholders are wise to approve the deal before Covad burns through its cash, said Stephanie Wickouski, a bankruptcy specialist and partner in the law firm of Arent Fox.

"The creditors who have the best success in recovery are the ones who reach a settlement very early on, before a lot of time and money has been spent [in litigation]."

Rosner said bondholders of NorthPoint Communications, which shut down in March, received no more than 1¢ on the dollar and that the goal of Covad bondholders was to take away as much cash as possible. In the future, Rosner believes other telecom companies are learning a lesson and will initiate negotiations with creditors instead of waiting until options are limited.

"I don't know the particulars of the Rhythms situation, but I'd like to think I could have negotiated a deal," Rosner said. "[Rhythms' creditors] may not have tried to negotiate early enough. The key is acting quickly and not spending too much time litigating while cash is being burned and it's too late."

Focal Communications avoided a similar fate last week by striking a deal under which its largest bondholders will exchange $280 million of high-yield debt for equity that will amount to about 35% of the company's outstanding shares.

However, getting to the negotiation table requires the cooperation of Focal's bondholders.

"A symphony of players was involved here," said Robert Taylor, chairman and CEO of Focal. "These companies did an exhaustive amount of due diligence. They don't want to invest a dime unless they are absolutely, positively sure that they are going to see a healthy return."

Covad's bondholders also received stock-now trading at less than $1-that McMinn vows to make attractive to investors.

The new lease on life for Covad gives credence to the wholesale model, McMinn said, noting that 39 of Covad's 50 regions will be "recurring cash contributing by the end of the year."

"What we have done is prove that the wholesale business does indeed make sense," McMinn said.

That's an overstatement, according to Mike Goodman, senior analyst for The Yankee Group.

"If your business model is, 'We're going to take people's money and not pay it back--and they're going to be happy about it'--then yes, they've proven that that is a successful business model," he said.

Still, Goodman calls the bondholder agreement "a good deal" for Covad that may let it overcome problems inherent in the model. "What you're seeing, more or less, is that [Covad] got their network for free. It's totally changed the dynamics of the business model."

With Rhythms' demise, Covad will be the lone nationwide provider of business-friendly symmetrical DSL (SDSL)--a market in which Covad already owns more than a 50% share, McMinn said. This should be a significant advantage, but Tier 1 businesses--the kind of customers that would bolster Covad's bottom line most--may balk at working with a CLEC fresh out of Chapter 11, said Kathie Hackler, vice president and chief analyst in telecommunications for Gartner Dataquest. 

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Covad's biggest operational threat remains the RBOCs. With next year's expected deployment of ShDSL--a new symmetrical DSL standard created to work better in RBOC networks-incumbents can market symmetrical DSL directly to businesses.

In fact, with more than 330,000 customers, virtually no debt and a low stock price, Hackler and Moore say Covad will be an attractive takeover target for Bell companies. Moore said SBC, which owns 6% of Covad and has a three-year contract for SDSL service with the company, would be the most likely buyer.

Finding a buyer for Rhythms, meanwhile, is proving to be a monumental task. In fact, there is some doubt whether anyone will be interested in its assets, which are expected to be available at fire-sale prices through a bankruptcy auction.

"The only history we have is AT&T purchasing the NorthPoint assets, and I don't think that sets a pattern for anything else," said Harry Taxin, president and CEO of MegaPath, a broadband ISP partner of Covad and Rhythms. "NorthPoint had a lot of trouble even selling those assets, and that may speak to the fact that that may still be the case out there."

Indeed, Hackler said AT&T was a special case because it had no DSL infrastructure. One possible candidate for Rhythms' assets is Verizon Communications, Moore said, noting the company's offer to buy NorthPoint last year.

SBC and Verizon declined to comment on any potential acquisition or asset purchase.

Even without interest in Rhythms or its assets, the DSL community is relieved there will not be a repeat of the NorthPoint debacle, an embarrassing episode for the industry in which 100,000 end users were stranded without service.

"This is not a NorthPoint," said Dan Foster, senior vice president of MegaPath. "They've got money in the bank and they've got a 31-day advance notice, so there's not a NorthPoint scenario where it just went dark one day." 
Kevin Fitchard, Glenn Bischoff and Vince Vittore  contributed to this article.