Carrier Channel: End of the Line?

Posted: 09/2002

End of the Line?
Upstart Metro Wholesalers Struggle to
Hang On, Investors Cut Losses

By Josh Long

SIGMA
NETWORKS DID NOT FAIL because its management was incompetent, nor was the
company’s wholesale strategy irrational, say former employees and analysts. Why
then would a telecommunications upstart managed by a team of seasoned
executives, including former Federal Communications Commission chairman Reed
Hundt, suddenly opt for liquidation? The answer: Investors decided to cut their
losses after forking over approximately $40 million in operating capital,
explains Ian McPherson, Sigma’s former product management director. Aside from
the operating capital, Sigma financed most of its build through Cisco Systems
Inc. vendor financing and monthly agreements with companies such as Metromedia
Fiber Network Inc. and Level 3 Communications Inc., he says.

Investors and Sigma’s management
decided to sell the company’s networks, says former Sigma spokeswoman Laura
Segal. The parties identified a need for the company’s wholesale services over
the long run, but the turnaround in telecom spending is not likely to begin
until next year, Segal says. That is a long time to sustain a startup, she adds.

The capital crunch in the
telecommunications market raises the likelihood that remaining wholesale
metropolitan carriers soon will face the possibility of a merger, bankruptcy
filing or liquidation process, industry analysts say.

At the bare minimum, metro carriers
have ceased speculative building. CityNet Telecommunications Inc., a company
that raised $275 million to build last-mile networks in sewer pipes, is among
those companies. "We are not going to stop building in other markets. We
are just not going to start building … on spec," says spokesman Lee
Allentuck.

CityNet recently disclosed it had
cut its staff and hired Rick Pontin, former president and COO of Broadwing
Communications Inc., to replace Robert G. Berger as CEO. The company is focusing
on selling wholesale capacity over networks in Albuquerque, N.M., and
Indianapolis and expanding its relationship with the local government in a Los
Angeles pilot program.

Allentuck would not say how much the
company spent while in construction and negotiations to secure rights of way in
city sewers. So far investors have supported CityNet solely on its promise.
CityNet has signed rights-of-way agreements in 16 cities. Allentuck notes the
Silver Spring, Md.-based provider recently signed its first wholesale agreement
in Albuquerque to serve one of the country’s largest cable operators. Two city
rings in Indianapolis nearly are built.

Meanwhile, privately held companies
such as Looking Glass Networks Inc. could face a shortfall of cash, particularly
if its customers continue to limit capital expenditures. A Looking Glass
executive said the company was in decent shape as long as the market prospects
don’t continue to sour.

The problem: Although a few
high-profile companies such as Covad Communications and McLeodUSA Inc. have
emerged from U.S. bankruptcy courts this year, the competitive telecom sector is
mired in a Catch-22 between conservative spending and a dire need for revenue
growth. The Bell operating companies have lowered their guidance for 2002
including their capital expenditures, citing sluggish demand in the business
sector. Bankrupt long-haul carriers are struggling to salvage their identities
and restructure their balance sheets while bankrupt competitive local exchange
carriers such as XO Communications Inc. face the same challenges.

These pressures aren’t likely to
help metro wholesale carriers reach their revenue and earnings goals. Senior
analyst Seth Libby of The Yankee Group says embattled long-haul carriers such as
Global Crossing Ltd. and Williams Communications Group Inc. are expected to
comprise a hefty portion of the metro carriers’ revenue.

"These guys aren’t buying right
now and if they are buying, they are buying very selectively," Libby says.
"They were some of the drivers for dark fiber and transport in these
markets. A substantial piece of the market is sitting on the sidelines right
now."

The austere market conditions have
laid the foundation merger activity. In August OnFiber Communications Inc.
announced it had acquired most of the network assets and customer contracts of
Telseon for pennies on the dollar.

OnFiber, a privately held company
based in Austin, Texas, acquired most of Telseon’s assets, valued at $85
million, for between 5 cents and 20 cents on the dollar, said OnFiber marketing
director Michael Rees. Communications Industry Researchers analyst David Gross
says Telseon barely avoided closing its doors by raising $20 million in January
after CEO John Kane got on his "hands and knees begging from the investment
community." The company raised $206 million in equity and secured $75
million in vendor financing.

In an interview, Kane says the
company lost half its recurring monthly revenue over time as a result of
bankruptcy filings. Consequently, Telseon’s sales team had to keep selling new
accounts just to maintain current revenue. If Kane could go back in time to the
Internet boom, he says he would have not turned down $230 million in capital
offered in 2000 — a decision he made because he thought the easy money would
dilute the company’s equity value.

Kane says Telseon investors
apparently figured out early this year they either would have to seek out a
consolidation strategy or "dump a lot more money in for a much longer
period of time." They chose the former, although OnFiber’s Rees says those
investors would receive some equity in the company but no cash.

Looking Glass Networks, a privately
held company that has raised $475 million in equity, bank capital and vendor
financing, also could face the same challenges as Telseon over the long haul.

Looking Glass Networks CFO Sunit
Patel says the company exceeded the point of maximum losses on earnings before
interest, taxes, depreciation and amortization (EBITDA). "We are past the
period of maximum EBITDA losses and we have a fair bit of cash on the balance
sheet, and with the continued support of investors and banks we feel comfortable
we will weather this crisis," Patel says.

In early June the company decided to
bring down the size of its Cisco-backed vendor financing facility from $100
million to $50 million, a spokesman says. The facility is more in line with the
company’s projected capital expenditures.

Patel says the company had at least
$100 million in its coffers as of April. The cash is available — not simply
money a company can borrow provided it meets certain milestones. The company
expects to reach EBITDA positive at some point toward the end of next year and
free cash flow positive in 2004.

Rod Woodward, a senior analyst at
Frost & Sullivan, wonders how much more money Looking Glass investors are
going to be willing to pony up the next time around? "I guess it [the metro
wholesale model] hasn’t proven yet it works," Woodward says. "I am
going to hold off for another year."

Patel says a bankruptcy filing is a
"possibility today for most carriers in the telecom business" and the
fate of Looking Glass Networks and others largely depends on whether the
industry continues its downward spiral.

He also does not rule out the
possibility of a merger down the road. "If the industry continues to go
down then a lot of people will come under pressure, not just us, for that
matter," he says. A company spokesman adds: It is "pretty apparent the
industry is ripe for consolidation."

Many upstart companies lacking a
mature revenue stream are at the mercy of market forces. Sigma touted a
"smart build" strategy to link telecommunications hubs, including Bell
central offices, carrier hotels, data centers and Internet access points, in
only five cities. Led by Hundt and CEO John Peters, the privately held company
raised $430 million mostly through Cisco vendor financing, McPherson says. The
company never disclosed publicly how much it spent.

Had the equity investors given Sigma
management $20 million to continue to fund its business, contributing nearly
half of the $130 million in operating capital, they probably would have
committed to the startup for the long term," says McPherson, who now works
as an optical networking analyst at Communications Industry Researchers. There
would have been a "mental buy-in," he says. (Benchmark Capital, a
Sigma investor, declined comment.) The killjoy: Investors saw little visibility
in a metropolitan wholesale sector characterized by slower customer growth than
they had envisioned, McPherson says.

Sigma is not the only metropolitan
carrier that has opted to sell its metropolitan fiber assets. On May 3, OnFiber
disclosed it had acquired metro networks in four markets from Sphera Optical
Networks for $2.3 million as part of a Chapter 11 filing. OnFiber estimates it
paid less than 10 cents on the dollar for Sphera’s assets. Sphera marketing
director Larry Chesel declined to comment on the reasons for the bankruptcy
filing. The Mayfield Group, a large investor in Sphera Optical, also declined to
comment.

Gross, of Communications Industry
Researchers, says heavy debt is not totally responsible for the shakeout in the
metro space. The upstarts simply couldn’t grow fast enough, he says. Although
some nascent companies have made noise about a healthy debt-to-equity ratio, a
more accurate financial metric is a company’s debt-to-revenue ratio, Gross says.
A company generating little monthly revenue can’t afford to make interest
payments on its long-term debt, he points out.

Moreover, some upstarts, including
Ethernet carrier Yipes, burned through a huge amount of cash each month only to
garner marginal revenue, Gross says. Yipes filed a Chapter 11 bankruptcy
petition in March. Gross, who has a master’s degree in accounting from George
Washington University, reckons Yipes had a $20 million annual run rate but was
burning through $10 million to $15 million a month.

Yipes, an Ethernet services provider
to business and carrier customers, reported a 64-percent revenue increase from
2000 to 2001. For a venture-backed startup, that is not impressive, Gross says.
"Obviously if you are BellSouth it is off the charts."

In July Yipes Enterprise Services
Inc. acquired the network and assets of Yipes. A spokeswoman refused to disclose
how much the company paid for the assets.

New York-based FiberNet Telecom
Group Inc. is a publicly held company that was on the verge of a bankruptcy
filing this summer. On May 6, the company announced reaching an agreement with
its lenders to convert $25 million of debt into preferred stock. Two months
later FiberNet announced it was seeking to raise equity or restructure the
company’s finances some other way. On July 12 FiberNet’s senior lenders agreed
to extend the due date of interest payments due in the first and second quarter
to Aug. 14. FiberNet operates metro networks in New York, Chicago and Los
Angeles.

"There can be no assurance that
we will be able to successfully consummate a financing or a broader
recapitalization on acceptable terms or at all," the company said in a
regulatory filing with the SEC. FiberNet posted $31.2 million in 2001 revenue,
up from $13.1 million in 2000.

FiberNet CFO Jon A. DeLuca says the
company had 88 customers and 114 interconnection agreements at the end of the
year. The company’s three largest customers — Qwest Communications
International Inc., 360networks Corp. and Network Plus Corp. — accounted for 53
percent of revenue in 2001.

Qwest has struggled the most out of
the four Bell companies, recently suffering federal investigations into its
accounting practices and credit-rating agency downgrades to junk status. Network
Plus went belly up and sold its assets to Broadview Networks. And 360networks is
tied up in bankruptcy court. However, 360networks, the Vancouver-based carrier,
continues to purchase services from FiberNet in North America, says FiberNet
vice president of sales and marketing Joe Leuci.

Metro Wholesale Outlook
Note: 2001-2005 figures are
estimates
Source: The Yankee Group