Dress Warmly If You're Headed to Market

Posted: 11/1997

Dress Warmly If You’re Headed to Market

Frostbite Can Be a Bear

By Debera Bell-Beam

There’s a distinct chill in the air, and it’s more
than seasonal. Investors no longer are infatuated with
possibilities that once accompanied a young, no-holds-barred long
distance market that set out to redefine itself on the heels of
deregulation. Unmet revenue and growth projections have left them
somewhat indifferent to flirtatious attempts to attract attention
and, more importantly, money.

Turning a cold shoulder to long distance, investors
have focused their attentions elsewhere-namely on telecom’s local
side. But, they are a fickle lot, and long distance is still
enticing under the right conditions. Investor interest still can
be piqued by international players and integrated phone
companies.

Crunching the Numbers

The total long distance market is valued at $220 billion of
which long distance takes $85.2 billion, based on a report by
Bear, Stearns & Co. Inc., Competitive Long Distance Carriers,
(June 1997). Local exchange carriers account for $107 billion,
while wireless carriers take $28 billion. Findings indicate
traffic growth slumped from 12 percent annually to between 6
percent and 7 percent in the early 1990s with a recent rebound to
the 10 percent area. New voice, data and video services–both
wireline and wireless–bode well for continued traffic growth
over the long term.

Taking a Pulse

Flat to down has been the pulse rate for many long distance
companies that have gone public over the past three years, says
Michael Blackburn, principal, Nashville-based Richland Ventures.
Analysts agree that unfulfilled projections have attributed to
investor caution and selectivity–indifference, according to
some–but a defensible business plan that turns a commodity phone
company into an integrated telecommunications service provider
can whet investor appetite.

"If you’re in the commodity long distance business, it
isn’t the place to be," says Richard Lukaj, vice president
of investment banking, New York-based Bear, Stearns & Co.
Inc. But there’s still plenty of opportunity for long distance
providers who have a business plan, product offering or marketing
plan they can implement to differentiate themselves from their
competitors, he says.

However, commodity long distance companies are finding
themselves unwilling participants (victims) in a blood bath that
is leaving some fatalities in its wash and others barely holding
on. Several insiders agree that selling long distance alone no
longer is a viable plan. "No matter how cheap the price is,
(customers) want more," says Blake Bath, senior
telecommunications analyst, New York-based Lehman Brothers.
Customers now demand full-service offerings. Moreover, recent
research by Lehman Brothers has shown that once customers buy
data services–an explosive new product offering–they are less
likely to leave the vendor.

Investors are looking for "special players that have
something valuable on a stand-alone basis and incredible value on
a strategic basis," Lukaj qualifies.

Most Likely to Succeed

Financial markets are always looking for some type of tangible
measure of where a company is and where it is going, says
Bradford Harries, president of Alexandria, Va.-based The Columbia
Group Inc., the broker-dealer affiliate of Columbia Capital Corp.
The focus includes such data points as churn, the company’s
customer base and the probability that the current revenue stream
is repeatable for some number of quarters forward. These data
points are key indicators of a company’s likelihood of future
success. Poor indicators result in lowered stock prices, and
"financial markets end up with a bad taste in their mouth
for that particular company," he says.

"One of the reasons the interest level has gotten very
soft is that companies can’t themselves demonstrate where the
profitability is going to be for some of what used to be their
core businesses. You can’t make a lot of money just selling
straight long distance," Harries says. "There’s got to
be other products, other services–and hopefully higher margin
services–that you are also selling to that customer in order to
achieve and maintain the profitability." Financial investors
are looking for growth and profitability. Right now, many have
been able to show growth, but not profitability.

Erratic Behavior

Second- and third-tier long distance companies have performed
erratically in the market over the past year, according to Bear,
Stearns’s report, which defines second- and third-tier carriers
as those that trail WorldCom. WorldCom runs behind AT&T, MCI
and Sprint (the Big Three). Early 1996 was an exceptional time
for long distance with a 33 percent climb attributed to momentum
investors. Considerable slowing occurred in the second half of
1996, due in part to regulatory uncertainty and skepticism about
Wall Street’s growth expectations vs. reality. At the time of
Bear, Stearns’s report, stocks were down by roughly 37 percent
from their June 1996 highs.

The negative reaction was overdone, according to the report,
and better second- and third-tier companies can expect robust
growth in the next two to three years at an estimated 20 percent
to 30 percent on average. In fact, Bear, Stearns predicts a
strong rebound as the regulatory dust settles, with ample
opportunity for small operators to grab share from AT&T and
weaker players.

Sentimental Journey

The ride’s over for those who enjoyed seemingly unlimited
market opportunity in the heyday of AT&T deregulation. Unlike
today’s local side–somewhat bullish–the long distance side is
currently "very bearish," Richland Ventures’ Blackburn
says. People perceive the competitive local exchange carrier
(CLEC) side as the current big market opportunity ("The
Dream vs. The Reality: CLECS Go to Market," X-CHANGE,
October). They don’t see much opportunity on the long distance
side, "because it’s already been exploited," Blackburn
says. "It’s 14 years old."

A number of publicly traded long distance resellers have seen
their prices decline over the last several months, observes
Capers Easterby, president, Greenville, S.C.-based Emergent
Equity Advisors Inc. Easterby notes price per minute is
declining, which he attributes in part to AT&T’s aggressive
pricing, which makes deep cuts into other companies’ earnings.

To combat competition, companies–successful ones, that
is–have found unique distribution strategies or specific
geographical concentrations that help them negotiate better
networking deals. Easterby says they also use such techniques as
volume leveraging to get better prices and protect thinning
margins.

But Easterby and other market insiders say small long distance
companies that were created in the wake of deregulation should
consider mergers and acquisitions if they are to survive in a
fragmented market that is taking a turn toward consolidation.

Uncertainty remains the theme for now with investors more
willing to bet on larger long distance companies–WorldCom, for
example–than on smaller players. Marketplace sentiment has
changed dramatically, Blackburn says. "The bets now are
being made more on companies that are consolidating and less on
companies that are embarking on a strategy to grow themselves
just internally."

Going Public

With a cool front moving in on long distance, no significant
deals of late have occurred in the domestic arena, market
analysts say. But, they add, the international side is telling a
different story. Of late, some high-profile, international long
distance providers have taken their initial public offerings
(IPOs) to market.

Regardless of whether a long distance company is domestic or
international, though, going public cuts both ways. Be careful,
or the repercussions may be severe, market analysts warn.
"You must have reached a level of maturity in your
business–that you can anticipate what your quarterly earnings
are going to be, because you will be asked to present what you
think the world looks like. What kind of sustainable growth rate
do you have? What kind of sustainable margin do you have?"
Columbia Capital’s Harries says. "If you aren’t able to meet
those expectations, the market will kill you."

On the one hand, a company must sell itself. On the other,
projecting an inflated image that the company cannot live up to
carries with it a huge price tag. "You sold me one thing,
and it isn’t that. You told me the house was above the flood
plain, and, then, the Mississippi rose," Harries
illustrates. "I’ve got water on my steps. You know, this
house isn’t worth $100,000 anymore."

Others agree. "That’s why you don’t need to go public
unless you’re really of the size and have the growth to meet the
market’s expectations for 30 percent to 50 percent growth and
earnings," Richland Ventures’ Blackburn says.

Typically, offerings are set at a minimum of $25 million,
carrying an equity valuation of no less than $75 million, with
roughly one-third of the company going up for public sale.
"In telecom, this means you must be about a $50 million- to
$100 million-revenue company today to be considered,"
Blackburn says.

Going public can be a good move when a company’s critical mass
is in place–both in terms of financial and management
ability–to sustain a growth rate of 25 percent-plus per year
consistently, and the company can deploy the proceeds of its
public offering to accelerate growth.

Analysts cite two good reasons to go public. First,
historically it has been less expensive to raise equity capital
in the public market as opposed to the private market, which
means less ownership will be relinquished. Second, public stock
can be used as currency to make acquisitions.

The International Front

Unlike domestic long distance, the international arena offers
greater investment opportunity, at least in investors’ eyes, for
now. In fact, the international side of long distance is almost
exactly opposite of its domestic half. "Investors still
perceive extraordinary margin opportunities and, therefore,
return characteristics available on the international side,"
notes Bear, Stearns’ Lukaj.

Numerous global partnerships and acquisitions have been in the
news of late, attesting to strategic positioning. ACC Corp. for
example, has signed an agreement to purchase United Telecom Ltd.,
a prepaid calling card and long distance provider based in the
United Kingdom. Recent IPOs have been made by the likes of Star
Telecommunications Inc., Telegroup Inc., RSL Communications Ltd.,
Startec Global Communications Corp. and Axiom Inc., just to name
a few in the telecom strata.

Last June, Star announced an IPO of 4 million shares of common
stock at $9 per share. In August, the wholesale provider of
international long distance, based in Santa Barbara, Calif.,
reported revenues in the second quarter totaled $82,707,000, a 93
percent increase over revenues of $42,852,000 in the prior year
quarter. For the six months period ended June 30, Star’s revenues
topped $153,715,000, a 96 percent increase over revenues of
$78,519,000 in the same period of the previous year.

"Those, by any standards, including the hottest
technology IPOs of the last decade, are incredible revenue growth
curves," Columbia Capital’s Harries says.

More recently, Star announced it will acquire Santa Fe,
Calif.-based L.D. Services Inc., which moves Star into the retail
sector of international long distance. For the six months period
ended June 30, L.D. Services reported revenues of about $15
million and was profitable.

In July, Axiom Inc. (formerly Securicor Telesciences Inc.),
Moorestown, N.J., announced completion of an IPO of 2.6 million
shares of common stock priced at $12 per share. Axiom is a
domestic and international provider of billing data collection
and traffic management solutions.

Also in July, Fairfield, Iowa-based Telegroup completed an IPO
of $40 million, expanding its global presence with plans to
increase its international network.

In August, Bethesda, Md.-based Startec, a long distance,
dial-around company, announced its intention to sell 1.9 million
shares at $9 to $11 each, anticipating as much as $20.9 million
in proceeds to help finance its international expansion.

Also in August, New York-based RSL filed an IPO for both
domestic and international availability, stating in company
reports it intends to use the proceeds for strategic merger and
acquisition activities, including potential acquisitions, the
purchase of additional interests in international cable systems,
and additional transmission and switching equipment.

Hey, Dime Lady

While the international half of long distance is taking
strides of global dimensions, the domestic side is fairly limping
in comparison. Resellers are among the stricken. In fact,
analysts say small resellers could soon top the endangered
species list if current market conditions continue as expected.
Switchless resellers in particular face peril ("The Death of
a Salesman," PHONE+, September). And, not far behind, the
traditional long distance phone company could join their ranks,
some warn. "There’s a lot of concern about the viability of
the small reseller right now," Richland Venture’s Blackburn
says.

The switchless reseller historically has made money through
service differentiation or small markets ignored by larger
providers. Generally, resellers offer some distinctive customer
service opportunity or delivery mechanism. "And, frankly,
most of their customer bases were small, and no one else called
on them, so it was to some degree a cream-skimming
strategy," Bear, Stearns’s Lukaj notes.

But resellers are feeling "a bit of a squeeze right
now," says Lehman Brothers’ Bath, citing aggressive retail
pricing, increasing capital requirements and rising network costs
as some factors contributing to that squeeze. Also, "because
there’s a bit of a shortage in long distance capacity out there
right now, a lot of the wholesale vendors are raising prices to
the resellers."

There’s also concern about commodity telephone companies who
basically have just one asset, the customer base, Lukaj says.
While margins are continuing to get skinnier, the consumer is
getting smarter and more demanding, thanks to education efforts
paid for by long distance providers. The result is increased
competition and even thinner margins. "Everybody’s heard of
the dime lady," Lukaj says, "or 10 cents per minute,
any time, any day, no gimmicks."

Resistance is Futile

Market insiders also report that investors are skittish in the
face of long distance entry by the Baby Bells. The regional Bell
operating companies (RBOCs) loom like a specter that threatens to
crush second- and third-tiers in a hard run at the Big Three.
Most believe they will take market share from their former
parent, AT&T, but not all believe RBOC long distance entry
will be harmful to small long distance providers.

Emergent Advisors’ Easterby says the move may prove beneficial
rather than detrimental in some instances. For example, the
regional Bells may want to acquire rather than build their long
distance empires by assimilating small long distance companies, a
strategy some CLECs also are going to consider.

This could be especially good news for switchless resellers,
because a company with network assets may desire what switchless
resellers can bring to the table–scale and easy geographic
expansion.

"I don’t think it’ll be good for the smaller carriers
unless they are being bought by the RBOCs," Lehman Brothers’
Bath says. RBOCS are likely to target the residential market and,
secondarily, the small-business market. "Smaller long
distance companies can come out ahead of game if they’ve
repositioned to offer local, data and Internet," Bath says.
"Companies that stick with just long distance, I think
that’s a pretty dire scenario."

A Lesson in Hubris

The telecom industry today brings with it a sense of deja vu
to those who remember the 1980s, whether speaking of long
distance and the break-up of AT&T’s monopoly or the
breathtaking spike skyward followed by a nauseating free-fall to
earth that characterized the personal computing industry. The
latter offers much by way of a lesson hopefully learned, Columbia
Capital’s Harries says.

"In terms of the consolidation of the industry, I am
frankly concerned that this industry may experience a similar
fate of the personal computer industry of the early ’80s, when in
1982, there were more than 165 manufacturers of what became known
as personal computers (PCs). A few, short years later, there were
between four and eight PC manufacturers," Harries says.
"The lion’s share of the difference between those two
numbers did not merge and consolidate to become larger PC
manufacturers. The vast majority of them went out of
business."

Harries looks at long distance resellers and hopes they share
nothing in common with the fate of PC manufacturers, but his is,
nonetheless, a cautionary tale.

"The issues that presented the opportunity for resellers
were in large part driven by regulatory changes, including the
split up of AT&T. A wide swath of opportunities was left
open, which the RBOCS were incapable or unwilling to take
advantage of, and they left this great opportunity for
resellers."

Harries says there is a strong probability "that a whole
bunch of these resellers will just go out of business and
disappear," which he attributes to "the ever-present
conflict between greed and reality."

Many resellers may not be worth as much either on a multiple
basis or in absolute dollar terms as they believe themselves to
be, and that may be their fatal flaw. "They push and they
hold out for a better price, a price they think is more
reflective of their value, and suddenly the floor falls out from
under them," Harries says. "It happened a lot to the PC
guys. A lot of the PC guys should have consolidated. They didn’t.

"They thought they were worth more than they were, and
all of a sudden, they were out of business–just out of
business," he says. "So I’m concerned that unless you
see real activity in terms of the consolidation of these
companies, some of them could just fail. The tide can turn very
quickly."

It Won’t Fit on a Business Card

A moniker like integrated telecommunications services company
evokes great expectations if a company can be judged by the
number of syllables in its name. The truth is, those expectations
already exist. Customers have begun to expect more from their
long distance company than just long distance. Moreover,
customers may come and go with a phone call, but increased
services can give them a significant reason to stay, Emergent
Equity’s Easterby says. Besides, diversifying offerings is one
way to hedge against thinning margins, especially when
premium-priced enhanced services–conference calling, for one,
boasts typical gross margins of up to 55 percent on retail
conference call rates ranging from 19 cents to 40 cents a minute,
depending on the type of call–can create real revenue
opportunities ("Resale Report," PHONE+, June).

While providers expand their offerings, they also should be
building a nationwide network to control their cost side through
network facility ownership, thereby, decreasing their dependence
on other long distance providers, Bear, Stearns’s Lukaj says.

Raleigh, N.C.-based Business Telecom Inc. (BTI) and West
Point, Ga.-based ITC^DeltaCom are two companies that have
repackaged themselves to become integrated telecom providers.

BTI, a privately held long distance carrier, got its start in
1983, buying capacity from AT&T and MCI. Since then, the
switch-based carrier has added such services as wireless,
Internet, nationwide paging and, now, local service. BTI recently
merged with its sister company, a CLEC named FiberSouth. BTI has
begun wholesaling extra capacity, and the company has its eye on
the cable industry, according to company reports. Also, BTI
recently closed a $250 million financing package to fund its
expansion plans.

ITC^DeltaCom, which began as a switch-based long distance
provider in 1982, now offers retail long distance and local
services to mid-sized and major regional businesses in the
southern United States as well as wholesale long-haul services,
according to company reports. Its offerings today include local
exchange and long distance voice and enhanced data, Internet and
operator services, and the sale and service of customer premise
equipment.

Also, ITC^DeltaCom has an interconnection agreement with
BellSouth Corp. for resale and access to unbundled network
elements and is a certified CLEC in seven of nine BellSouth
states.

Growth+ Earnings=Reward

The equation is simple. And, market analysts cite two
strategies toward that end: One, find a unique niche to grow
rapidly through internal growth. Two, consolidate. Richland
Ventures’ Blackburn says Telco Communica-tions Group Inc. is a
successful company that employs both strategies. Based in
Chantilly, Va., Telco, a switch-based provider, offers
dial-around residential services through direct-mail marketing.
The niche provider has experienced revenue growth at a compound
annual rate of 209 percent from $45 million in 1994 to $429
million in 1996, according to Bear, Stearns’ report.

Telco recently took advantage of the consolidation strategy,
announcing plans to merge with Excel Communications Inc., a
switchless reseller in the residential market segment. Excel also
has experienced amazing revenue growth at a compound annual rate
of 247 percent, from $31 million in 1993 to almost $1.3 billion
in 1996. Dallas-based Excel employs a unique multilevel marketing
structure that encourages independent representatives to recruit
new reps, according to Bear, Stearns.

Other notables trumpeting growth strategies include LCI
International, described by Bear, Stearns as a company with
strategic flexibility and one of the best management teams in
telecom. In September, McLean, Va.-based LCI revealed it will buy
U.S. Long Distance Communications Corp. (USLD), San Antonio,
Texas, in a $331.8 million stock transaction. USLD focuses on the
payphone sector and the hospitality industry and is expected to
enter the local services market, according to Bear, Stearns.
Combined, the two companies claim total consolidated 1997
revenues of $1.6 billion. The transaction expands LCI’s domestic
geographic presence and market coverage in the Southwest and
Northwest, further increasing its customer base in the West and
Southeast. LCI also agreed to buy a 729-mile dark fiber route
over the SONET (synchronous optical network)-based long distance
network under construction by IXC Communications Inc., giving LCI
coast-to-coast fiber connectivity and one of the lowest service
costs (net of access charges) in the industry, Bear, Stearns
says.

Over the Rainbow–Somewhere

Additional opportunities for long distance may be found in
local services and newer services–Internet access, data
transmission and the like. Some analysts say the industry is
about five years shy of taking advantage of local service, but
the outlook is good. Competitive long distance companies are just
beginning to tap into local service–a significantly larger
market expected to account for a good deal of the industry’s
top-line growth in the coming years, according to Bear, Stearns’
report. By capturing "a mere 1 percent share of the local
market in 1998, revenues could increase by an additional $1.2
billion for a group of companies whose revenue base is around $10
billion today," according to the report.

Analysts generally agree that long distance providers most
likely to succeed are the best of the second and third tiers,
which makes a good argument for consolidation whether a company’s
strategy is to position itself to make an acquisition or to
become the acquired.

The Urge to Merge

Small players who take advantage of consolidation may find the
measure beneficial from both an offensive and defensive stance.
Regardless of motivation, however, the trend is a natural
occurrence that in the next few years is expected to hit the CLEC
market as well ("Mergers and Acquisitions: Coming to Terms
with Competition," X-CHANGE, September). "Mergers and
other consolidations can be a potent competitive force. The
synergies that result from combining assets may create from two
small, less efficient firms a large, more efficient one,"
FCC Chair Reed Hundt recently said in testimony before a Senate
subcommittee on competition. "The effect can be actually to
deconcentrate the market, as the newly created and newly enabled
merged firm wins market share from incumbent market leaders.
However, mergers can also be defensive reactions against new
competition, a way to establish a cove in the cozy harbor of
monopoly power."

Richland Ventures’ Blackburn notes that not everybody can
become a WorldCom, but they can become attractive to a WorldCom
instead. (At press time, the market was reacting to reports that
WorldCom had offered to buy MCI for $30 billion–just as MCI was
on the verge of closing its deal with British Telecommunications
PLC. At the same time, WorldCom confirmed it will acquire Brooks
Fiber Properties Inc. for $2.9 billion.

Companies under $100 million in revenue need to begin to merge
among themselves to get themselves bigger so they are attractive
on a take out to an LCI or a WorldCom. "Right now, we’re in
a period where the bigger players have now been consolidated with
few exceptions," Blackburn says, naming ACC Global Corp. as
one.

Moreover, scale becomes increasingly important to gain
selling, general, and administrative (SG&A) cost efficiencies
and become more attractive to acquirers, Lehman Brothers’ Bath
says. "You want to gain scale and build quickly, when your
business is in a relatively healthy state." In other words,
Bath warns against companies waiting until they are in trouble to
begin consolidation efforts.

Emerging consolidators on the lower end of the spectrum are
the likely future for long distance, primarily in the private
sector where there is more flexibility and more willingness to
work with sellers to structure transactions that they’re
interested in vis-a-vis financial and management components,
Blackburn says. But Bear, Stearns’ Lukaj says there will be much
activity on the public front as well, and the market can expect
cross mergers among public and private players.

Sam Walton Would be Proud

Eventually, combinations of long distance and local will
result in "all distance" companies, which may create
new opportunities. But "there’s really nobody making money
as a CLEC right now that I know of," Richland Ventures’
Blackburn says. "That’s today. In four or five years, they
probably will be making money. That’s what people are betting on.
They’re not betting on it today. They’re betting that four or
five years down the road, it’s going to be a good business."

Others say all distance companies are just over the horizon.
"Before long, everybody in CLEC land will be calling
themselves all distance companies," Bear, Stearns’ Lukaj
says. The questions then become how you bundle; how you
integrate; how you target customers that need certain elements of
the bundle; and how you repackage your products.

"It becomes really a marketing, billing, packaging and
distribution business–just like any other business where your
differentiator is not a unique product or technology, because
there won’t be much proprietariness in any of that," Lukaj
says. "It’s really going to be how you market, sell,
integrate, engineer, provision–all those simple things that make
Wal-Mart exciting."

Lukaj says the winners are going to be those that match their
business plans with the end of the telecom-service spectrum that
they choose to address. Very high-end service players along the
Nordstrom model have been successful. Then, there are those who
go down market and address very small- to medium-sized
businesses. They must be streamlined, very low cost, for customer
acquisition and provisioning and very targeted in their marketing
campaigns–much oriented like the Wal-Mart model.

For more information regarding Bear, Stearns & Co.
Inc.’s Competitive Long Distance Report (June 1997), call
Michelle Wolf at (212) 272-8700.