They Say That Merging Up Is Hard To Do

Driven by a frenzy of activity

in the wireless industry, the megamergers reminiscent of the dotcom era have resurfaced - but the same cannot be said for competitive wireline providers.

Competitors like McLeodUSA Inc. are still grappling with the fundamentals - growing revenue, meeting bank covenants and avoiding delisting on the Nasdaq. Stock prices in the CLEC industry have tanked on the heels of disappointing financial results and other developments.

The senior executives of numerous phone and Internet companies tell PHONE+ they adamantly support consolidation to drive scale and improve the balance sheet.

“We get it and we understand it’s necessary and it needs to happen,” says Xspedius Communications LLC President and CEO Mark Senda.

Although companies are combining regional assets, there are few really big deals. One reason: CEOs say investors are reluctant to assume a heap of debt or pay a premium for a company that is in a dire financial position.

Keith Wilson, CFO of PAETEC Communications Inc., says it can be more difficult to acquire a struggling firm than a healthy one because the weaker company tends to be “more defensive about value.”

“I think there is a lot of interest in trying to consolidate to achieve some scale and some synergies,” Wilson says. “I think on the larger side those things have been slow to come” because buyers and sellers don’t agree on price.

PAETEC revealed plans in January to acquire American Long Lines Inc., a telco serving business customers in the mid-Atlantic region. American Long Lines reported revenue of $24.5 million and net income of $1 million in 2003, according to PAETEC; sources estimate PAETEC, a private company based in Fairport, N.Y., generates about $400 million in annual revenue.

Wilson says American Long Lines and PAETEC generate free cash flow, a key milestone among investors. Free cash flow is the amount of money a company has left over after it has paid its expenses, including investments. “We expect to be able to double their free cash flow,” Wilson says.

Carl Grivner, CEO of XO Communications Inc., says investors looking to put a deal together want to see companies generating free cash flow. The problem is that the competitive industry is still losing money. XO reported a third-quarter net loss of $43.6 million. Grivner says XO is planning to generate free cash flow sometime this year, which is “probably the best indicator you are going to make it in this industry.”

XO created a big buzz in the competitive industry approximately one year ago when it announced plans to acquire Allegiance Telecom Inc. Analysts say XO has faced bigger challenges integrating Dallas-based Allegiance than it had projected. Its stock price has been cut in half over the last year.

Grivner maintains the company is ahead of schedule to achieve $160 million in savings through the merger. And he says XO has the same number of employees as it did before the merger - 5,000 - while Allegiance will add hundreds of millions of dollars in annual revenue. With the addition of Allegiance, XO is expected to generate $1.5 billion in annual revenue, compared to $1.1 billion in 2003.

“I think there is a lot of buzz in the industry right now about further consolidation,” Grivner says.

ITC^DeltaCom Inc. is one competitor that was expected to lead the wave of consolidation. The West Point, Ga., company closed a merger with BTI Telecom Corp. in 2003. And in September, it announced two merger agreements, which would have positioned the carrier as a bigger rival to BellSouth Corp. and other Southeast competitors. In December, however, ITC^DeltaCom announced the mutual termination of a merger agreement with FDN Communications Inc. The merger closing was a condition of a second combination involving ITC^DeltaCom and NT Corp., the parent company of Network Telephone Corp.

Needham & Co. analyst Vik Grover says the merger agreement collapsed as ITC^DeltaCom’s “stock blew up on weak [third quarter] results, and [the] valuation was likely unacceptable to sellers of FDN and NTC.”

In a filing with the Securities and Exchange Commission, ITC^DeltaCom provided a vague explanation for terminating the planned merger.

“In approving the termination, ITC^DeltaCom’s board of directors considered that ITC^DeltaCom was unable to take certain proposed corporate actions in compliance with preclosing operating restrictions in the merger agreement without FDN’s consent,” ITC^DeltaCom stated in the filing. “Because FDN did not grant its consent to those actions, ITC^DeltaCom’s board of directors determined that the companies would be unable to complete the merger on the terms originally negotiated and approved by ITC^DeltaCom’s lenders.”

ITC^DeltaCom posted a wider net loss in the third quarter, drew $15 million under a credit facility (which had not been anticipated) and issued a correction to its results, saying it understated the costs of revenue. Shares of ITC^DeltaCom closed Jan. 5 at $1.46 on the Nasdaq, down from $4.67 the day it announced the merger agreements with FDN and NT Corp.

Chief executives say it is not easy getting as far as ITC^DeltaCom had come in striking the merger agreements. Xspedius’ CEO Senda cites the myriad number of equity and debt investors that can make it difficult to complete an agreement. All the groups, he adds, are vying for the biggest piece of the same dollar.

“We’ve pushed through what we think are the tough times. I am a little personally disappointed we haven’t got more done” to consolidate, Senda says, but he adds it is not due to a lack of effort.

“We have to be much more creative in the kinds of deals” we attempt to close, Senda says, noting that striking an accord is not as simple as cutting a check or issuing equity.

Richard Smith, the president and CEO of Eschelon Telecom Inc., says his company has strict criteria for acquiring a firm: the company must be operating in the same territory as Eschelon; it must support the same business segment and have the same product set; and the pact must improve EBITDA immediately and add to cash flow within two years. “We follow that model religiously. That’s why we haven’t done more acquisitions,” Smith says.

In January, Eschelon Telecom announced completing the acquisition of Advanced TelCom in a $45.5 million stock agreement. Smith says the deal will boost its annual revenue by 35 percent based on third-quarter results and grow its EBITDA. Eschelon posted third-quarter revenue of $40.6 million, EBITDA of $6.1 million and a net loss of $4.3 million.

Smith says Eschelon is still interested in more deals. One possibility: hooking up with a rival in the Pacific Northwest: Integra Telecom. “I think some day a transaction like that will probably happen,” Smith says. “That may take three or four years to get done.”

Venture capitalists and private equity firms have been principal investors behind recent mergers and acquisitions in the competitive wireline industry. Some executives say a resurgence of the public equity and debt markets could hasten consolidation.

First, however, competitors will have to show investors their telecom business is not a money-losing venture. The big deals just might have to wait until competitors ride out of the red.

“We’re biting off things we could chew of a reasonable size,” Eschelon’s Smith says. “When you try to do too much with not enough bandwidth of your management team, I guarantee you’re going to have problems.”