A necessary evil

Last year a lot of chickens came home to roost from the telecommunications industry’s go-go days, as share prices throughout the sector tumbled. But for competitive local exchange carriers in the U.S., 2001 was nothing short of brutal. Licensed to compete with the regional Bell operating companies for local service and to keep RBOCs from exploiting their monopoly positions, many of the fledgling CLECs had operational problems. Others had too much debt or too many competitors. At least ten - some of them very large - filed for bankruptcy in 2001. That number jumps to more than 30 if related companies, such as Internet service providers, Web-hosting companies and digital subscriber line providers, are included.

Investment bankers and analysts say the filings and liquidations are a needed rationalization of the market. “These bankruptcies are something of a necessary evil,” says John Otto, head of Citigroup’s global telecommunications practice. “There is overcapacity in the telecom sector.”

Still, the bankruptcies disrupted business, cutting off communications. “There is no question that bankruptcies and financial difficulties have affected current and prospective customers,” says Ken Kotylo, telecom analyst at William Blair & Co. “For the business customer in particular, telecommunications is an extremely important service. It is not like buying a new tube of toothpaste.”

If a business enterprise relied on NorthPoint Communications for part of its telecom service, it was out of luck when AT&T Corp. bought some of bankrupt NorthPoint’s assets in 2001. Because it did not purchase the company outright, AT&T did not continue to provide service to NorthPoint’s customers. “About 90,000 businesses were all of a sudden in the dark,” says Romeo Reyes, vice president for high-yield telecom research at Jefferies & Co.

The bankruptcies make the regional Bells even stronger. Gary Rabin, head of telecom banking at CIBC World Markets, notes that the disruptions some customers experienced will help RBOCs sell their products. “If you’re a salesperson, one of the first things you have to say is, ‘How could you sign up with an upstart? You’re going to get your service shut down. With us, you’ll be able to sleep at night,’” Rabin says.

Attempting to ward off difficulties, some troubled telecom companies are turning to voluntary restructuring before they have to file for Chapter 11. “It can be better, because bankruptcy hamstrings the company and essentially destroys value,” says Davis Terry, head of telecom investment banking at UBS Warburg.

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In a recapitalization existing investors typically trade in their debt for equity, enabling companies to borrow again for working capital. Focal Communications Corp. announced its recap in August, and XO Communications and McLeodUSA - both funded by private equity firm Forstmann Little & Co. - are also recapitalizing. Bondholders are realizing that it is better to recapitalize because there is very little liquidation value in CLEC assets. Their best chance to recoup their investment is to restructure a company’s balance sheet to keep it in business.

Six months ago, says Robert Siegel, head of telecommunications corporate finance at Jefferies, investors would not have considered buying into the beleaguered sector. Their appetite for telecom is returning. “The VCs are starting to circle,” he says.

But the telecom sector is not out of the woods yet. Bankers predict a second shakeout. Scott Moskowitz, leader of the telecom group at Bear, Stearns & Co., says the market still has a further 12 to 18 months of turmoil ahead. Christopher Harland, head of telecom investment banking at Morgan Stanley, says there will be a wave of recapitalized companies that will eventually file for bankruptcy. “Restructuring gives companies a new lease on life,” Harland says. “The question is whether they will survive after the recapitalization.”

Shakeout in the making
Competitive local exchange carriers were set up to compete with the Baby Bells and offer customers a choice. Some have proved to be less than competitive. Now they’re going out of business, recapitalizing or are in Chapter 11 protection in an attempt to stay alive.