Read My Lips

Posted: 06/1998

A PHONE+ Exclusive

Read My Lips
International Buying Alliance Gives Multinational Carriers a Raspberry

By Khali Henderson

At the Intelsat-hosted global traffic meetings in Washington in May there was at least
one new player at the negotiating table: the Telecom Buying Alliance (TBA), a consortium
of some 50 small- to mid-size long distance carriers that represent an estimated 50
million minutes or more of international long distance traffic. After 10 months of being
unable to secure an underlying carrier agreement, the group’s facilitators and members
have formed their own global gateway in competition with the established and emerging
multinational carriers they say snubbed them. In this unprecedented move, members of the
alliance will own nearly one third of the new carrier, called SynergetEx.

Alliance facilitator and, now, SynergetEx’s chief executive officer Joe Sadoti said the
new strategy was necessitated by fruitless negotiations with underlying carrier
representatives who he believes had no intention of doing a deal with the alliance.

"They had no interest in writing down their existing business to gain traffic from
the alliance members. They paid lip service to [working with the alliance], but they had
no intention of doing it," says Sadoti, who spent an estimated $200,000 of his own
time and money to support the TBA’s yearlong effort. "What’s more irritating [than
the loss of time and money] is that the underlying carriers were not listening to what the
market was saying. These are their customers, not mine. I guess they thought if they just
ignored it, it would go away."

But a spokesman for one of the bidding carriers denies these charges. Ken Hilden, vice
president of client services for Santa Barbara, Calif.-based STAR Telecommunications Inc.,
says negotiations stalled because modifications to the contract which were verbally agreed
to by Sadoti were not made in writing by the TBA’s attorneys. Hilden did not recall what
those modifications were. "After this happened a few times, we figured they did not
want to do the deal and went on to other things," Hilden says, adding that STAR’s
last contact with the TBA was in late January or early February. Hilden also notes that
STAR was not concerned about writing down business to existing customers because, although
the carrier was not aware of who the alliance members were, it did not expect significant
crossover between the alliance membership and its own customer base.

"We are surprised by the accusation," he says. "We thought that the
alliance would introduce us to a whole new group of carriers and bring us a lot of new
business."

In response to the specific claims made by STAR, Sadoti says in the final contract
proposal sent March 5, the TBA "agreed to every one of STAR’s requests, including
those that were not in the TBA’s best interest.

"In spite of our willingness to meet STAR’s demands, STAR never signed this
contract and we were left with no choice but to follow up on other proposals coming to us
from within the TBA membership," Sadoti says.

Because negotiations with other bidders were conducted under non-disclosure, PHONE+
was unable to request comment from other potential underlying carriers with which the
alliance was negotiating. However, last August, after the alliance’s initial request for
proposal was issued to lackluster response, a spokesperson for one major carrier’s
wholesale arm told PHONE+ his company’s reasons for not bidding on the alliance
traffic. First, he said, the company would negate its investment in its direct sales force
by dealing with aggregators that take a percentage off the top and, second, it would
simply be lowering its price since many alliance members are its current customers.

"I think that all the underlying carriers were short-sighted," Sadoti says.
"In the end, it put us in a position to have to develop a whole new model to address
the issue [of achieving better international wholesale rates for small carriers]."

History

The TBA was formed in spring 1997 in response to smaller carriers’ desire to remain
competitive in a market that it claims disadvantages low-volume buyers with wholesale
rates that are not decreasing at the same pace as retail rates. To secure better rate
structures enjoyed by the larger carriers, the alliance hoped to artificially create high
volumes of international traffic by aggregating minutes of several carriers under one
contract. One larger alliance member said that its support for the group is the result of
Tier One carriers "flexing their muscles" and increasing international wholesale
prices. The group issued its RFP in mid-June 1997. Absent bids from the first-tier
international players, Washington-based FaciliCom International won the TBA contract–then
70 million minutes valued at $6 million to $10 million per month–from a field of
second-tier and international gateway long distance providers in September. Less than
three months later, the growing alliance announced that it would pursue a multicarrier
strategy to accommodate its diverse traffic and began entertaining proposals from various
emerging international carriers, such as STAR Telecommunications, with expectations for
contracts in hand by year-end 1997.

While its new suitors initially came to the table with attractive pricing schedules
giving alliance members an average 25 percent savings over current rates, Sadoti says
negotiations were artificially drawn out by one-sided amendments and even "the
proposal’s in the mail" stall tactics. Very soon, Sadoti says it became clear that
the alliance’s overtures were not being taken seriously and that it would need to exercise
a greater degree of control over its destiny by owning its own switch.

A New Approach

Uniquely, New York-based SynergetEx will give its reseller customers–i.e., alliance
members–the ability to pool their minutes to achieve lower rates as was the alliance’s
intent. In addition, they will have an opportunity to earn equity in the company based on
their usage. The company’s shares are divided equally at 28 percent among the TBA members,
Sadoti’s company Spring Mountain Communications (SMC) and officers of the North American
Communications Control Inc. (The remaining 16 percent will be distributed as needed to
personnel recruited to staff the joint venture.)

SMC is under management contract to provide sales and marketing. As mentioned, Sadoti
will serve as the venture’s CEO. NACC, a six-year-old, $20 million long distance carrier
with a Lucent 5ESS at 60 Hudson in New York City, is under management contract to provide
SynergetEx with switch partitioning, network management and billing services. NACC’s
President James Milana will serve as SynergetEx’s chief operating officer.

Telecom veteran Jon Peterson will join the company as its president and chief financial
officer. Peterson comes to SynergetEx after a lengthy career in telecommunications
including 12 years as controller and, later, chief financial officer with Fairchild
Communications Services Co., a shared tenant services company owned by Fairchild
Industries. Peterson was vice president of finance for the company after it merged in 1996
with Shared Technologies and tendered its initial public offering. Most recently, he was
vice president and CFO for Plexsys, a manufacturer of wireless communications switches and
base stations.

Although the details of the shareholder plan were not finalized at press time, Sadoti
says the TBA’s 28 percent will be earned over five years, heavily weighted in the first
three years. Alliance members will have a vesting period of two years, after which they
can exercise their options for a nominal price.

No stranger to telecommunications finance, Peterson says he is unaware of a similar
business model. "I thought it was ingenious to provide an opportunity for the
customer to be involved in the corporation. It becomes a long-term venture vs. a
short-term possibility for them," he says. "The customer shares in the
management and is involved in the decision-making. The more [customers] participate the
better their equity as well as their rates."

The primary challenge for the group is to achieve critical mass quickly, Peterson says.
The shareholder agreement newly crafted, the alliance members have yet to review the
opportunity. Based on a superficial understanding of the SynergetEx plan, Mike Daughtry,
director of operations for alliance member UNICOM, Bend, Ore., says he expects alliance
members to jump on the opportunity assuming they can get to the gateway in a
cost-effective manner so as to preserve the expected international rate advantages.

"[Alliance members] will want to do it if the rates adjusted for backhaul are
equal to or better than they could get on their own. What would make them stay is the
equity option," Daughtry says. He adds that the plan also requires alliance members
to trust those managing the gateway to negotiate good international pricing while building
a financially profitable gateway company.

"Equity participation means that you’re betting over seven years the gateway
company will be profitable," he says.

Daughtry expects that the SynergetEx model will be especially attractive to the
alliance members with significant international traffic volumes. "A handful [of
members] will get the vast majority of the equity. The rest of us will get a minor
share," he says. "[For a smaller international player such as UNICOM], good
rates would be the primary driver for participation, but equity options add to the
attraction. In the end, we can’t pay more than we otherwise would pay for international
termination in order to receive a very minor equity role in the gateway company."

Sadoti says the final shareholder plan, awaiting approval by the board of directors,
would address the interests of the smaller alliance members.

Carrier Agreements

SynergetEx is negotiating global termination with multiple carriers, including an
unnamed regional Bell operating company (RBOC). While no conclusive agreement has been
reached with SynergetEx, a spokesperson for the Bell company says "on the surface it
appeared to be the kind of deal they would like to do." This relationship, if forged,
also could improve the backhaul part of the equation for the smaller carriers.

The officers of the new carrier see significant opportunities for the venture arising
from the Federal Communications Commission’s Foreign Participation Order. That order
enables foreign PTTs to connect to carriers in the United States, obviating the need for
U.S.-based international carriers to lock into a lengthy indefeasible right of user (IRU)
agreement.

"A lot of carriers have managed to work out their own direct operating agreements.
That window has come and gone. The PTTs are contacting us from overseas looking to put
facilities in New York. Why would we want to buy a direct circuit when they are going to
meet us at 60 Hudson?" says Milana. "This dynamic will provide the rate
structures and competitive advantage the alliance needs."

SynergetEx had scheduled meetings with several foreign PTTs such as Swiss Telecom, Hong
Kong Telecom and Telecom New Zealand at the Intelsat-hosted global traffic meetings.
Milana expected the company to have six to 12 carrier agreements in place by mid-May,
coincident with the Telecommunications Resellers Association (TRA) conference in San
Francisco.

Implications

To underlying carriers who viewed Sadoti as an opportunist seeking to cash in on
six-figure monthly commissions, his formation of SynergetEx likely will confirm their
suspicions. Sadoti’s company’s stake could be worth a small fortune by anyone’s standards.
However, Sadoti has a built-in rebuttal because he is awarding alliance members with
nearly a third of the equity in the company, a heretofore unheard-of gesture.

Considering current international carrier market caps of greater than $1 billion, the
potential value of that equity is in the hundreds of millions of dollars. For example, at
press time, a 28 percent stake in Pacific Gateway Exchange, an emerging multinational
carrier based in Riverside, Calif., would be worth approximately $300 million. Equity
participation for alliance members could be viewed as a gamble because it assumes that
SynergetEx management will successfully grow the company in a highly competitive
environment driven by margins of 15 percent or less, says Casey Freymuth, president of
Group IV Inc., a Phoenix-based international telecommunications consulting firm.
"However, since they have to buy traffic anyway, if the rates are competitive, equity
is a perk that no one else is offering," Freymuth says. "So, if there is no
monetary cost, why not roll the dice?"

Freymuth says he likes the equity-driven approach in concept, but notes that the
SynergetEx model doesn’t leave equity available to venture capital firms or other
investors. "If SynergetEx achieves the rapid growth the alliance did in pooling
minutes, funding growth could be an obstacle down the road," he says. "Sadoti
and his crew are going to have to run a tight ship or risk diluting their ownership."

A regular contributor to PHONE+, Khali Henderson is principal with Marcom, a
Phoenix-based marketing communications firm to the telecommunications industry. She can be
reached at [email protected]