a complex and multifaceted set of regulatory proposals means no simple
answer (and having spent many, many hours recently with a number of
analysts and reg-wonks, I don't have the time currently to put it
together here). So I recommend that you read the analyst reports that
are here for some introductory and bottom-line analysis.
Here are the first call notes for Grubman's call today (in which he
distinctly contradicted Jacob's analysis):
CLEC stock sell-off on special access issues completely unfounded
Salomon Smith Barney
Thursday, August 05, 1999
--SUMMARY:----Telecommunications Services
*The CLEC group has been under pressure due to several factors.
*We think the overwhelming factor behind the CLEC sell-off is macro market
concerns about higher rates & liquidity issues, which hurt DCF stories last
summer. *The CLECs we follow are fully funded through 2000 and we believe
access to capital is not an issue. *Given that Internet stocks are more
than 50% off their highs, CLECs & bandwidth players do trade a bit like
derivatives of the Internet names, adding fuel to the fears over
liquidity and rising interest rates. *Any portion of CLEC sell-off due to
fears about RBOC pricing flexibility for special access is unwarranted.
This is a worry that is in a time warp of 10 years ago, when CAPs were the
only competitors. Today's CLECs get virtually no revenue from dedicated
access services & are entirely end-user focused, selling switched svcs.
--OPINION:------------------------------------------------------------------
The CLEC group, along with other non-earnings type stories, like our
bandwidth plays and most Internet plays, have taken it on the chin over
the past couple of weeks. On average, the CLECs are 20% off their highs,
tracking a pullback in Internet and other emerging-growth, non-earnings
stories. Despite this pullback, the CLECs are still up 80% year-to-date,
up 62% over a 52 week period, and up 223% from their October lows. Thus,
some perspective needs to be kept, since this is a high beta group that
will be volatile when fears of rising rates seep into the market. The
CLECs however, are a host of companies building new assets, accessing a
huge array of business customers, poised to take tremendous market share
and clearly, as Paul Allen demonstrated with his Allegiance investment,
represent a strategic partnership potential for an array of players.
When the CLECs were at their highs not long ago, many investors fretted
about missing out. At this point, nothing fundamental has changed, yet
the group is now trading at very attractive valuations. The median CLEC
valuation is trading at 3.7 times 2000 net plant and 5.2 times 2000
revenue, both at or only slightly above RBOC multiples. And, more
importnatly, these are below similar valuation metrics of a year ago,
despite one year's worth of good operational progress. Also, current
valuations are implying an average cost of equity of 24%, which is high,
given a realistic risk profile of the group. This is a group with real
assets taking market share in a huge industry and with increasing
strategic value. Furthermore, every CLEC we follow is fully funded
through the end of 2000. This set of attributes does not suggest a risk
profile more than double that of the incumbent RBOCs who have legacy
assets and are losing market share.
Another issue not helping this group is the perception by newspaper
reporters and some other analysts that RBOC flexibility on special access
pricing is somehow a death knell for the CLECs. We do not believe this
makes sense. The CLECs have all been built to provide end-user switched
services to business customers, and thus any pricing flexibility on the
part of Bells for special dedicated access is entirely irrelevant. As
seen in the table below, except for ICG and Hyperion, who have embedded
CAP revenues (and have dedicated access of roughly 12-13% of 2000
revenues), no other CLEC we follow has dedicated access as a percent of
revenues above 3%. Since the market seems to have focused on these names,
we note that NEXTLINK has 3% and WinStar and Teligent have zero revenues
from dedicated access. Furthermore, MFNX isn't even a CLEC, it supplies
dark fiber to every local competitor including the RBOCs.
-------------------------------------------------------
CLEC % of Revenues from Special Access
-------------------------------------------------------
Allegiance 0%
Hyperion 13%
ICG 12%
Intermedia 0%
McLeodUSA 0%
NEXTLINK 3%
MetroMedia Fiber 0%
Focal 0%
US LEC 0%
WinStar 0%
Teligent 0%
-------------------------------------------------------
Let's tackle each of these issues one at a time:
Macro Market Impact
It seems to us that stock activity in DCF stories is becoming rather
seasonal. Each year over the past four years, emerging telecom stocks
have typically doubled to quadrupled from roughly Thanksgiving through
the end of the second quarter of the following year. Over the past two
years, this volatility has been particularly pronounced. We are not sure
why they follow this pattern, but clearly if the market worries about
rising interest rates and drying up liquidity then clearly DCF,
non-earnings stories, be it CLECs bandwidth stories or Internet
companies, will suffer, which is why the betas on these stocks are very
high. As far as the CLECs we follow are concerned, since the capital
markets were quite accommodating from November of last year through June
of this year, every CLEC we follow is fully funded through 2000, with
some CLECs, such as Allegiance, fully funded for their entire business
plan. Thus, fears of rising interest rates and liquidity issues for the
broader market, while not surprisingly hurting day-to-day stock
movements, does not impact ability of the CLECs we follow to implement
their business plans.
We remind investors that on October 8, 1998, the CLECs hit bottom, only
to go up an average of 223%, even accounting for the most recent
sell-off. We believe that once macro market concerns about interest rates
and liquidity run their course, the CLECs will rebound once again. Among
the non-earnings types of stories in the marketplace, these have real
businesses, have a huge market to shoot at, are taking tons of market
share, and have valuable strategic assets. This is why the snapback from
last October was rather rapid. We suggest investors keep this in mind,
lest they miss another sharp rebound.
Internet Connection
We cannot scientifically prove it, but we do believe that the CLECs and
bandwidth names are increasingly becoming correlated with Internet stocks
in their price movements. We are not sure this is justified. We can see
the point, though, that for Internet plays--such as web hosting, content
providers, portals, and infrastructure providers--their fortunes are
clearly tied to the fortunes of companies building new network assets.
Thus we do believe, for better or worse, the fortunes of CLEC stocks will
be increasingly correlated with the Internet space, given that the
Internet and, in particular, applications such as e-business over the
Internet will become a massively important part of the overall economy.
Despite short-term volatility, we believe that it is a good thing for
CLEC and bandwidth stocks to be correlated with what is no doubt the
fastest growing segment that this economy has ever seen.
Special Access
The FCC will rule that the RBOCs will be allowed pricing flexibility on
special access. To view this as a negative for the CLECs is a time-warp
view. Ten years ago when MFS and Teleport were doing solely competitive
access services, solely on a dedicated basis, if the Bells then got
pricing flexibility for special access we never would have had a
competitive local industry. This was similar to long distance. AT&T did
not get off tariffs until the early 1990's. This was well after MCI,
Sprint and others had fully developed their business plans to offer
end-user services. We remind investors that in the eight years after AT&T
got pricing flexibility, they have continued to lose share and
competitors grew revenue and profitability quite robustly. Had AT&T been
de-tariffed in 1984, there would be no competitive long distance
industry.
In fact, pricing flexibility for the RBOCs for special access has been
around for years. The Bells have had the ability to offer term and volume
discounts for dedicated access for the last several years. Thus, in
reality the RBOCs have been de facto deregulated in special access in the
marketplace for many years. All the old CAPs have migrated themselves to
providing local switched services, with the two original CAPS, MFS and
Teleport, part of MCI WorldCom and AT&T. Thus, the special access
business of MFS and Teleport are literally rounding errors within
WorldCom and AT&T. Secondly, the dedicated facilities that MFS and
Teleport have into end user building are used solely for connectivity to
large strategic business customers. Given that no Bell on the planet even
understands how to create a product that could satisfy the national and
global data needs of a large customer, the fact that RBOCs can do pricing
flexibility for dedicated access is completely immaterial.
As for the CLECs, every new CLEC created in the past five years has been
solely driven by offering switched services to end users. None of these
CLECs offer dedicated access services. Very few have facilities into end
user buildings. In fact, every CLEC is a net buyer of dedicated
facilities from their customers to points of presence in the network and
between facilities on their local network.
Thus, to view special access pricing flexibility for the Bells as a
negative for the CLECs is to entirely miss the point that the entire
industry is much more complex and that what seems on the surface to be a
benefit for the RBOCs is not at all a negative for the CLECs. This is
because there is no intersection between Bell special access and what the
CLECs are doing to drive revenue, namely providing switched dial-tone
end-user offerings using unbundled loops.
Some specific issues that have been raised include the fact that the
Bells' pricing flexibility somehow is a huge windfall for them. First of
all, the Bells will only have pricing flexibility on special access,
which on average is well below 10% of their total revenue. Secondly, they
will only be able to do pricing flexibility in areas where there are a
certain threshold of collocations by CLECs in the CO's. Thus, Bell
pricing flexibility will be in a subset of what is a rather small revenue
stream. In fact, it is not obvious to us that pricing flexibility is any
different than what is already in the marketplace today.
The second point being raised is that somehow this will raise the
break-even point for CLECs on a customer by customer basis, because of
the notion that pricing flexibility for the Bells will drop their rates
to customers by as much as $15 per month. We do not believe this is
correct. The CLECs sell switched dial-tone to customers that, on average,
use 10-20 lines of telephony. The CLECs buy unbundled loops or fractional
T-1s from the Bells. They are competing with Bell dial-tone. Special
access pricing flexibility has zero to do with the pricing of unbundled
loops or dial-tone to end users. Thus, the break-even for a CLEC will be
unaffected.
If anything, since special dedicated facilities is a cost element of the
CLECs, they are likely to see a decrease in part of their cost
structures, which lowers their break-even point.
Finally, there is an issue that CLECs are competitively disadvantaged by
pricing flexibility. Again, we do not believe this is true. Special
access is sold to carriers or to mega-large customers that want direct
connections to long distance points of presence. No CLEC is in that
business. Thus, a CLEC knocking on the door of a 20 line business
customer is completely unaffected by Bells being able to lower special
access pricing.
The bottom line is that this ruling by the FCC would have mattered 10
years ago. Just like they did in long distance, the FCC waited until it
did not matter to give the incumbent pricing flexibility, and gave
pricing flexibility on a service that the CLECs do not offer. There is no
CLEC we follow that will have one dime of revenue or EBITDA potential at
risk by this move.
NET/NET: CLECs are high beta stocks that swing up and down in big chunks.
However, they are building real businesses with real assets. Investor
should always take advantage of dislocations in a market like this in
order to load up the boat at good valuations. This strategy has worked
continuously for the last four years or so and we see no reason why it
will not work now. Aside from macro market concerns which we may not
agree with but which we understand, there is no other reason, especially
special access pricing flexibility, that should cause these stocks to go
down. We would load up the truck on these names since we believe this
group, once the market rights itself, will be poised for another big
run-up. Operating results are clearly accelerating and we are beginning
to see by virtue of Paul Allen, strategic interest begin again in this
group. |
