Where the Cash Flows

Posted: 10/1998

Where the Cash Flows
Who’s Funding New Investment in Long Haul?

By Gary Kim

For the past two years, the big story in U.S. carrier investment has been mergers and
acquisitions, especially among the larger facilities-based carriers. Since early 1997, at
least $278 billion has been spent on these telecom industry mega-mergers. On the long-haul
side of the business, the big news has been new outside investment of about $4.1 billion
committed to build new long distance carriers, several based on Internet protocol (IP) or
other packet technologies.

Debt financing has been the key factor, though new stock issues have raised new long
distance carriers about a few hundred million dollars. Traditionally, venture capital (VC)
commitments remain nil, except for a recent $10 million investment in North Brunswick,
N.J.-based ITXC Corp.

Merger and acquisition fever is likely to continue as industry players scramble to
achieve national scale and scope, expand their product portfolios and lower operating
costs through ownership or control of network facilities.

Until now, most of the big mergers have been horizontal, wherein players in one
industry segment combine and get bigger. "Defensive" mergers, which aim to
protect market share, are best seen in the Bell Atlantic Corp.-NYNEX Corp. merger and the
SBC Communications Corp.-Pacific Telesis Group merger. "Offensive" horizontal
mergers, such as the recent $10 billion AT&T Corp.-British Telecommuni-cations PLC
venture, aim to capture customer share.

The most notable exception to that general rule has been the proposed AT&T merger
with Tele-Communications Inc. That $48 billion deal melds two firms in distinct and
complementary market segments, and may be the first of a wave of vertical mergers
amalgamating differing core competencies. Indeed, analyst Daniel Zito of Legg Mason Wood
Walker Inc., Baltimore, says the most important trend over the next two to three years
remains the convergence of the long distance and local sectors.

"We expect that the major industry players will continue to consolidate and
acquire smaller entities in order to expand their geographic footprints and develop the
product portfolios necessary to compete," says James Henry, director of Bear, Stearns
& Co. Inc., New York.

Wealthy Parents

Much of the investment for new long distance packet networks comes from firms using
internal cash flow. Indeed, it has helped to have wealthy parents. Much of the capital
being deployed by three new facilities-based long distance carriers Qwest Communications
Interna-tional Inc., Level 3 Communications Inc. and Williams Communications Group comes
from internally generated resources.

Tulsa, Okla.-based Williams, for example, is committed to spend $2.7 billion on its
32,000 route-mile network, to be completed by the end of 2001. And the company is raising
much of the money from internal cash flow. It will spend $800 million in 1998 alone, and
has acquired long-term carriage contracts worth more than $1 billion from customers
including US WEST Inc., Englewood, Colo.; Intermedia Communications Inc., Tampa, Fla.; and
Concentric Network Corp., Cupertino, Calif. Likewise, Omaha, Neb.-based Level 3 has access
to about $2 billion in assets contributed to it by parent Peter Kiewit Sons Inc., also
based in Omaha, as well as $2 billion in bond financing.

Denver-based Qwest raised a significant $320 million war chest in its initial public
stock offering (IPO) last June. A huge run up in its stock price led to an all-stock
purchase of LCI International Inc., McLean, Va., and Qwest now boasts an $11 billion
market capitalization.

Debt Financing

Debt financing has been the key trend for new carriers raising new capital in 1998. IDT
Corp., for example, has raised about $119.8 million in net proceeds from its IPO, and
another $100 million in debt in two transactions, and further received $10.6 million in
debt financing from another two transactions in late 1997 and early 1998.

Privately held USA Global Link, Fairfield, Iowa, raised $81 million in 1997 in a
private placement of stock, on the heels of about $20 million raised in 1996, also in a
private placement.

Delta Three Inc., an IP-based carrier in New York, raised $165 million in its October
1997 IPO, and has taken on about $627 million in debt financing so far in 1998. Hamilton,
Bermuda-based RSL Communica-tions Ltd., which owns 51 percent of Delta Three, itself
raised $490 million in debt financing so far in 1998.

Venture capitalists, traditionally not a factor in carrier investment, have begun to
make some smaller moves into the business primarily by backing firms providing high-speed
local connections for Internet access. Price Waterhouse’s annual National Venture Capital
Survey for 1998 reports that only about $1.233 billion was invested in telecom companies
in 1997, mostly companies on the software and equipment supply side of the business.
Though a few digital subscriber line (DSL) companies such as Covad Communications Co.,
Santa Clara, Calif., also got funding, it remains the case that venture capitalists still
are largely absent from the carrier financing business.

ITXC Corp. is a rare example of a new long distance firm with VC backing. In May, the
company received $10 million in VC financing from Intel Corp., Santa Clara, Calif.;
VocalTec Communications Ltd., Herzliya, Israel; Chase Capital Partners, New York; Flatiron
Partners, New York; Spectrum Equity Investors, Palo Alto, Calif., and Boston; and DS
Polaris Ltd., Israel.

Investment Drivers

Though profit margins in the long distance segment continue to be squeezed, smaller
carriers remain attractive acquisition targets for several reasons.

Bundled services, optimally including local, long distance and data, are seen as the
dominant pattern for large and successful carriers. And for carriers without significant
U.S. market share, or without long distance share, acquisition of long distance
firms–with their customer bases and revenue streams–remains an attractive way to
establish a position.

So what’s driving investment in new facilities-based long-haul carriers? For starters,
the Internet explosion has created new bandwidth demands that investors believe will
outstrip existing capacity. "Band-width on the WorldCom (Inc.) UUNet backbone doubles
every three months," notes John Sidgmore, CEO of UUNet Tech-nologies Inc. in Fairfax,
Va.

Prospects for electronic commerce are another factor expected to drive enormous new
demand. Already, Cisco Systems Inc., San Jose, Calif., a leader in e-commerce, expects
half its 1998 revenue to come from e-commerce sources, according to the company. Barnes
& Noble expects to sell $200 million in books over two years, say researchers at
Hambrecht and Quist Ltd. Dell Computer Corp., Austin, Texas, meanwhile, sells $3 million a
day in personal computers (PCs).

Trends such as these have led investors to create a market capitalization for Yahoo! of
$8.2 billion, larger than the New York Times Co. Likewise, the market cap for Amazon.com,
at $6.2 billion, is larger than that of Barnes & Noble ($3 billion) and Borders Books
& Music ($2.9 billion) combined.

The prospect of a revolutionary shift in networking from the older circuit-switching
model to a packet-switching model also has spurred investments in the new long distance
networks. Lower operating costs aren’t really the issue. The ability to deliver new
services that seamlessly integrate voice, image, text and audio, and the requirement that
those networks be packet-based to the core, is the carrot.

So incumbent local exchange carriers (ILECs) are likely to be buyers of long distance
assets, says Bear, Stearns’ Henry. Close on their heels may come international carriers.
Since the U.S. market is close to half the value of the global telecom market, one should
expect international carriers to buy long distance and Internet assets as a way of gaining
entry to the lucrative U.S. market.

A frequent contributor to PHONE+, Gary Kim is strategic research director for
Convergent Communications Inc. in Englewood, Colo. He can be reached at +1 303 749 3061.