IPOs Are Back

The competitive telecommunications industry has been shut out from the IPO market since 2000. Now, at least three telecom carriers have revealed plans in recent months to take their companies public.

Cbeyond Communications, Eschelon Telecom Inc. and PAETEC Communications Inc. have filed proposed registration statements with the Securities and Exchange Commission for planned IPOs ranging in value from approximately $86 million to $175 million.

Cbeyond, Eschelon and PAETEC declined to comment about their IPOs, and several Wall Street firms arranging the public offerings did not respond to requests for comment.

Are these companies an anomaly, or do investors have a reason to believe again in an industry abandoned five years ago by Wall Street? Prem Parameswaran, emerging telecom sector head at Deutsche Bank, says competitive carriers took longer to prove their business case than investors had anticipated but now it is happening.

The business models did work but in fact it took a longer time to get to cash flow positive or break even, he says.

Mike Robinson, CEO of Broadview Networks, says there has been a general interest in the competitive sector over the last several quarters or possibly longer.

The [capital] markets are interested … in companies that have a business model that looks scalable, that looks like it can generate free cash flow [and] that is maturing, says Robinson, the former CFO of US LEC Corp.

He says investors also are looking at a management teams record of delivering results and facing challenges related to such areas as the state of the capital markets, technological changes and regulations.

I think there are a lot of companies that would like to tap the public markets whether its debt or equity or both, Robinson says.  Now there are more opportunities for people to access different types of capital in 2005 and 2006 than possibly were available in 2003 and 2004.

One likely reason:  competitive carriers have started to produce metrics investors value, such as free cash flow and net income. Of the three companies planning IPOs, two made it into the black last year:  Eschelon and PAETEC. Minneapolis-based Eschelon posted 2004 net income of $1.1 million while Fairport, N.Y.-based PAETEC reported a profit of $77.6 million.

Deutsche Bank has shown faith in the sector. Last year, the firm arranged a $150 million high-yield debt offer for US LEC, provided a $480 million exit financing package for RCN Corp. and raised more than $300 million in two private equity rounds for Vonage Holdings Corp., the largest Internet phone company in the United States.

The market is kind of ripe for some of these companies, Parameswaran says.  Parameswaran says traditional institutional investors and hedge funds are taking interest in the competitive sector.

The actual operations and execution of the companies is coming through and you can actually see that, he says. Investors start licking [their] chops because they understand the businesses.

But what does the recent spate of planned IPOs really mean? Lisa Pierce, a vice president with Forrester Research, does not believe the recent activity highlights a large revival in the competitive telecom industry.

Unfortunately, given the industrys current anemic state, I dont think these IPOs are indicative of a general widespread CLEC/alternate provider resurgence, Pierce says.

Indeed, the struggles facing the competitive telecom sector are evident in the sinking stock prices of public companies. For example, shares of West Point, Ga.-based ITC^DeltaCom Inc. were trading under $1 this summer on the NASDAQ National Market compared to approximately $5 the previous year.

Judy Reed Smith, CEO of ATLANTICACM, the research and consulting firm, says the companies planning IPOs have proven they can be successful in spite of a number of challenges, including a dearth of capital since 2000. I do think its exciting that there is finally money back in the telecom industry, she says. Theres enough regulatory clarity for Wall Street to see which business models [and] which companies are well enough managed to survive in spite of the regulatory hurdles challenging competitive carriers.

As of late, some investors have been particularly bullish on the IP phone business. That may help explain Cbeyonds appeal on Wall Street. The company sells local and long-distance IP phone service, broadband Internet access, Web hosting and other communications services to small businesses in Atlanta, Chicago, Dallas, Denver and Houston. Cbeyond anticipates using proceeds from its IPO to fund expansion into six more markets by the end of 2008.

Cbeyond announced its plans to go public on the heels of a $200 million round of funding Vonage raised to fund expansion in Canada, the United States and the United Kingdom.

Although investors are placing money back into a select pool of competitive telecom providers, including Internet-based phone carriers, Wall Street has its reservations. In assigning a below investment grade rating of B to PAETEC, Standard & Poors Ratings Services cited some risks facing the company.

Our corporate credit rating on PAETEC primarily reflects the companys lack of sustainable competitive advantages in a fiercely competitive telecom market, its small size, limited market share, and financial and operating risk associated with new acquisitions, S&P Ratings Services stated in a news release.

Risks, though, are nothing new to investors backing the competitive telecom sector. Says Parameswaran of Deutsche Bank: The returns are excellent for those who understand the risk.